Lara Cathcart

Pricing defaultable bonds: a middle-way approach between structural and reduced-form models

In this paper we present a valuation model that combines features of both the structural and reduced-form approaches for modelling default risk. We maintain the cause and effect or ‘structural’ definition of default and assume that default is triggered when a state variable reaches a default boundary. However, in our model, the state variable is not interpreted as the assets of the firm, but as a latent variable signalling the credit quality of the firm. Default in our model can also occur according to a doubly stochastic hazard rate. The hazard rate is a linear function of the state variable and the interest rate. We use the Cox et al. (A theory of the term structure of interest rates. Econometrica, 1985, 53(2), 385–407) term structure model to preclude the possibility of negative probabilities of default. We also horse race the proposed valuation model against structural and reduced-form default risky bond pricing models and find that term structures of credit spreads generated using the middle-way approach are more in line with empirical observations.

Market and Model Credit Default Swap Spreads: Mind the Gap!

Structural models of default establish a relation across the fair values of various asset classes (equity, bonds, credit derivatives) referring to the same company. In most circumstances such relation is verified in practice, as different financial assets tend to move in the same direction at similar speed. However, occasional deviations from the theoretical fair values occur, especially in times of financial turmoil. Understanding how the dynamics of the theoretical fair values of various assets compares to that of their market values is crucial to a number of market participants. This paper investigates whether a popular structural model, the CreditGrades approach proposed by Finger (2002), Stamicar and Finger (2005), succeeds in explaining the dynamic relation between equity/option variables and Credit Default Swap (CDS) premia at individual company level. We find that CDS model spreads display a significant correlation with CDS market spreads. However, the gap between the two is time varying and widens substantially in times of financial turbulence. The analysis of the gap dynamics reveals that this is partly due to episodes of decoupling between equity and credit markets, and partly due to shortcomings of the model. Finally, we observe that model spreads tend to predict market spreads.

Multiple Defaults and Merton's Model

Multiple defaults and default correlations are crucial inputs in risk management, credit derivatives, and credit analysis. An extension of the structural framework to accommodate multiple defaults provides a simple and unified framework for calculating single and joint default probabilities in closed form for more than two firms. The results are useful in various financial applications.

Implied liquidity risk premium in the term structure of sovereign credit default swap and bond spreads

In this study, we focus on the dynamic properties of the risk-neutral liquidity risk premium specific to the sovereign credit default swap (CDS) and bond markets. We show that liquidity risk has a non-trivial role and participates directly to the variation over time of the term structure of sovereign CDS and bond spreads for both the pre- and crisis periods. Secondly, our results indicate that the time-varying bond and CDS liquidity risk premium move in opposite directions which imply that when bond liquidity risk is high, CDS liquidity risk is low (and vice versa), which may in turn be consistent with the substitution effect between CDS and bond markets. Finally, our Granger causality analysis reveals that, although the magnitude of bond and CDS liquidity risk is substantially different, there is a strong liquidity flow between the CDS and the bond markets, however, no market seems to consistently lead the other.

The Correlation Structure of the CDS Market: An Empirical Investigation

Using an extensive data set of credit default swap (CDS) spreads on U.S. firms, we investigate the correlation structure of the CDS market. For comparison, we also examine the correlation structure of their equity returns. We find that although industry affiliation plays a central role in CDS correlations, so too does rating classification above and below investment grade. By contrast, the correlation structure of equity returns is characterized by industry affiliation. Our results highlight differences in the organization of these markets and the salience of the investment-grade boundary.

Reputational Shocks and the Information Content of Credit Ratings

There has been much scrutiny of the Credit Rating Agencies’ (CRAs) flawed ratings of structured products in the build-up to the financial crisis. Our study examines whether the ‘credit rating crisis’ altered the information effects of their traditional product, corporate bond ratings. Using an event study, we analyze the Credit Default Swap (CDS) market’s response to rating announcements by Moody’s between September 2004 and December 2009. Our results demonstrate that CDS price effects were considerably greater in the pre-crisis era, and document a possible spillover effect of reputational damage onto the bond rating services of the CRAs.

Media Content and Sovereign Credit Risk

We explore the impact of media content on sovereign credit risk. Our measure of media tone is extracted from the Thomson Reuters News Analytics database. As a proxy for sovereign credit risk we consider Credit Default Swap (CDS) spreads, which are decomposed into their risk premium and default risk components. We find that media tone explains and predicts CDS returns and is a mixture of noise and information. Its effect on risk premium induce a temporary change in investors’ appetite for credit risk exposure whereas its impact on the default component lead to reassessments of the fundamentals of sovereign economies.