Frank S. Skinner

An empirical analysis of credit default swaps

Abstract This article represents the first empirical examination of credit default swaps. We appeal to corporate and option pricing theory to argue that credit default swaps are actually put options. We suggest a linear regression model containing five variables that are important for pricing standard options. This empirical model shows that at least three, possibly four of these same variables are also important in pricing credit default swaps. Interestingly, we find that swap participants appear to manipulate the variables under their control to structure the amount of credit risk that is traded. Finally, we find that the credit default swap prices reflect the recent Asian currency crisis.

Duration for bonds with default risk

Abstract Does approximating duration estimates by ignoring default risk lead to error in the two major duration applications — measuring interest — rate price elasticity and immunization? We derive a general expression for duration in the presence of default risk based on Jonkharts term structure model (On the term structure of interest rates and the risk of default, Journal of Banking and Finance 3, 253–262, 1979) extended to encompass risk aversion. The model includes terms for default probabilities and default payoffs in each period as well as for a delay between the occurrence of default and the final default payoff. Our main conclusion is that practical duration applications involving bonds with default risk must employ duration measures adjusted for default risk.

Estimating Corporate Yield Curves

Tests of arbitrage-free pricing models show that we can expect less reliable corporate yield curve estimates than Treasury yield curve estimates. An examination of the structure of errors produced by common statistical yield curve models indicates that even with careful data selection, significant liquidity and tax-induced errors remain. It is a welcome result that the extent of the errors due to liquidity and tax effects is modest. Moreover, pooling bonds by broad rating category produces no significant deterioration in yield curve estimates.

An Empirical Study of Credit Default Swaps

This is an examination of the pricing of credit default swaps that traded around the dates of the Asian currency crisis using two different credit risk models. The cost of default insurance is generally found to be lower than the expected value of payments in the event of default. According to both models, the cost of default insurance is greater than the expected value of payments for credit default swaps written on entities domiciled in countries subject to the Asian currency crisis, a finding attributable to moral hazard.

The Original Maturity of Corporate Bonds: The Influence of Credit Rating, Asset Maturity, Security, and Macroeconomic Conditions

We examine the determinants of the new issue maturity of corporate bonds. As credit rating decreases, new bond issues have longer maturities, but substantial variation in maturity within each rating class remains. We seek to explain the variation of new issue maturity within credit classes. We find that asset maturity, security covenants, and macroeconomic conditions influence the new issue maturity of bonds within rating categories.

Hedging bonds subject to credit risk1

Abstract This paper provides a simple and practical approach to hedging bonds that are subject to credit risk. Three new hedge ratios are derived and tested and the roles of basis risk and diversification is investigated. Empirical tests reveal that basis risk is an important factor in hedging corporate bonds. These tests identify a need for new interest rate derivatives where the underlying asset is subject to credit risk.

Interest and inflation risk: Investor behavior

We examine investor behavior under interest and inflation risk in different scenarios. To that end, we analyze the relation between stock returns and unexpected changes in nominal and real interest rates and inflation for the US stock market. This relation is examined in detail by breaking the results down from the US stock market level to sector, sub-sector, and to individual industries as the ability of different industries to absorb unexpected changes in interest rates and inflation can vary by industry and by contraction and expansion sub-periods. While most significant relations are conventionally negative, some are consistently positive. This suggests some relevant implications on investor behavior. Thus, investments in industries with this positive relation can form a safe haven from unexpected changes in real and nominal interest rates. Gold has an insignificant beta during recessionary conditions hinting that Gold can be a safe haven during recessions. However, Gold also has a consistent negative relation to unexpected changes in inflation thereby damaging the claim that Gold is a hedge against inflation.

Predicting the Direction of Interest Rate Movements

This research develops a simple probit model for predicting the direction of long-term interest rates. One variation uses the slope of the term structure, and another uses the forward rate as a predictor variable. Out-of-sample tests on Federal Reserve data indicate that for a one-month forecast horizon, the model correctly predicts the direction of 5-, 7-, 10-, and 30-year yields with more than 60% success. The success rate is nearly as good when we use data obtained from yield curve estimates. While these results are not good enough to be the sole determinant in bond investment strategies, the model can provide useful information.

What will be the risk-free rate and benchmark yield curve following European monetary union?

Using a linear factor model, we study the behaviour of French, Germany, Italian and British sovereign yield curves in the run up to EMU. This allows us to determine which of these yield curves might best approximate a benchmark yield curve post EMU. We find that the best approximation for the risk free yield is the UK three month T-bill yield, followed by the German three month T-bill yield. As no one sovereign yield curve dominates all others, we find that a composite yield curve, consisting of French, Italian and UK bonds at different maturity points along the yield curve should be the benchmark post EMU.

Contingent Capital Securities: Problems and Solutions

We describe some recent contingent capital securities (CoCos) and explore the issues that confront their development. We take the view that bank CoCos should be designed to maintain confidence in a bank before a crisis begins because once a crisis commences it is difficult to see how a bank can assure the capital market without the support of state aid. With this overriding objective in mind we find that, in at least some respects, existing examples of bank CoCos have got the ‘right’ design. Existing bank CoCos are unfunded as they should be as there is no need to structure these securities to provide additional liquidity. If funding turns out to be necessary then a liquidity crisis is already underway and the CoCo has already failed in its attempt to maintain confidence in the bank. Moreover, existing CoCos use the simpler single trigger that we favour rather than dual trigger structure recommended by some.