Giovanni Calice

Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage

In a naked credit default swap (CDS) position, a party pays an income stream to a seller of protection to swap away default risk on an underlying defaultable security without actually holding this reference instrument. Using mark-to-market returns on a large cross section of CDS positions, held independent from their reference entity, we implement a novel test to establish whether their inclusion in an optimised portfolio is replicable by a large set of alternative assets. Overall, we find significant excess returns of over 28% per annum against an optimised benchmark, we speculate that it is these characteristics that could be driving a bubble in the CDS market.

Credit Risk Transfer and the Forecasting of Bank Defaults

The current financial crisis has brought into sharp focus the need for robust empirical analysis of bank default prediction models. The contagion currently affecting the banking sector has its roots in traditional banking crises, i.e. inflated asset valuations and poor risk management. The difference, however, between past crises and that which appears to have began in earnest in August 2007 is the presence of the credit derivatives (CDs) market. The transmission of credit risk via these types of instruments appears, according to international financial regulators, to have amplified the current global financial crisis by offering a direct and unobstructed mechanism for channeling defaults between financial institutions of a variety of types. This paper proposes a default risk model, in the vain of the classic Merton-type, which incorporates forward-looking measures of market and credit risk using the credit default swaps (CDS) market as a latent variable for forecasting asset volatility. We present a robust set of empirical tests to illustrate the effectiveness of this model over alternative specifications.