Credit Default Swap - Essay Example

? Credit Default Swap (CDS) 0 Executive Summary This report examines credit default swap (CDS), which is a recent innovation in the management of credit risks. It is a critical review report which deals with pricing, valuation and sensitivities of CDS spreads. In this report, research work that has been done by various authors is taken into consideration. It focuses on three key areas: One is the determination of the price of a single name CDS security and demonstration of how the price of a CDS is obtained for a listed company using a specific pricing model. Secondly, it presents a review of sensitivities and spillover effects on CDS spreads from bond, equity and options markets. Under this, the market that has the greatest influence is identified after considering statistical evidence from various sources. Finally, the report reviews credit default swaps in the context of monitoring sovereign risks in both developed and emerging market economies. This seeks to demonstrate how credit default spreads behave in tranquil and volatile market environments. In addition, the importance of CDS market development in emerging economies is also highlighted in this report. 2.0 Background Credit default spreads (CDS) are recent innovation in the management of credit risks. They have gained popularity in the management of both single name and sovereign debt risks. The market is valued based on information from related underlying equity, bond and their options markets. However, various challenges have been experienced when dealing with CDS markets. These challenges include pricing of CDS spreads, lack of exchanges for trading credit derivatives, manipulation of accounting information, among others. Pricing of the CDS spreads is not an easy task. Though various models have been put forward by many researchers, there is no universally accepted method of computing the price of CDS. Another challenge is the lack of exchanges for trading credit derivatives. CDS quotes are therefore obtained over the counter (OTC) and may not be reliable for estimating the CDS spreads. Spillover effects from the bond, equity, and options markets also affect the CDS spreads. The extent to which these markets impacts on the CDS spreads is not clearly known despite the various statistical methods posted by different researchers. Some suggested that equity markets have the greatest spillover effects on the CDS spreads while others argued that options market are the major contributors. Credit default swaps have been fully taken up in the developed economies while the emerging economies are still struggling to catch up. The way in which CDS behaves in tranquil and volatile market environments has sparked serious research. Many questions concerning CDS markets and their importance in the emerging economies have been raised by various researchers. How are sovereign risks managed by these economies? The application CDS in managing risks is a new innovation that requires further research. 3.0 Credit Default Swaps 3.1 Determination of the price of a single name CDS security. Many approaches of determining CDS spreads have been put forward by various researchers. One commonly used approach for pricing a derivative is by finding a portfolio of assets whose returns matches that of the derivative replicated. Duffie & Singleton (2003) and Lando (2004) suggested such portfolios in their research. This strategy may not work in a situation where similar replicating instruments needed for replicating the portfolio are not issued by the issuer whose CDS’s are being replicated. In addition, what happens to the replicating portfolio when the CDS contract ends after a credit event? Another approach of pricing CDS spreads is to determine the value of spread which equates the net present value of the expected value of the coupon to the net present value of the expected value of the payoff. Hull & White (2001) used this approach to formally derive the pricing formula. They assumed that interest rates, recovery rates and default probabilities are independent. The result of their sensitivity tests showed that the valuation of a vanilla CDS was not sensitive to the expected recovery rate but this was not the case for a binary CDS. Moreover, a spreadsheet based example, which shows an implementation of such an approach, is posted by Hull (2007) in his text book. Even commercial firms use algorithms which are not significantly different from this simple approach. Despite the assumption made by Hull (2007) that a default can only take place bi-annually; the current technology can accommodate daily defaults’ assumptions. This approach is mostly used to determine the mark to market value of existing CDS contracts by estimating the default probability out of the current spread. Dubey (2010) presented an alternative approach of determining single name CDS spreads by expounding on the Merton model of 1974. He argued that by viewing the equity of a firm as a put option, he will make a difference to the Merton model which viewed it as a call option. He suggested computational procedures to determine CDS spreads from the Merton Model. The advantage of this approach is that it gives an alternative way of computing the CDS spreads without calculating default probabilities as done in the Merton model. However, CDS quotes used could be misleading since they are obtained over the counter and not traded publicly. The exchange market for credit derivatives should be developed so that accurate market information can be gathered by one body (Driessen, 2005). 3.2 Sensitivities and spillover effects on CDS spreads from bond, equity and options markets. Trade among various markets results in spillover effects to other markets. Direct spillovers occur where the participants operates in multiple markets. These spillovers occur from one market to another in the bond, equity, options and CDS spreads markets. This paper focuses on the spillover effects on CDS spreads from the other markets. Arezki et al. (2010) studied spillover effects of news ratings announcements on different classes of assets across countries and financial markets. They found that news ratings announcements have significant spillover effects on both countries and financial markets. This may mean that such ratings announcements have negative impacts on the financial markets leading to financial instabilities. This could help explain the recent financial crises among the Eurozone countries. The solution is to tighten the rules and regulations governing the rating agencies in those countries affected. Avino, Lazar, and Varotto (2011) analyzed the price discovery and volatility spillovers in credit spreads from the option, CDS, bond and equity markets. The aim of this study was to detect volatility spillovers among the four markets by focusing on a time varying price discovery. The results of this study indicated that there were more volatility spillovers from the option market to the other markets in crisis periods. Though the study was under more than one topic, the results were credible since financial data used belonged to a specific period (2007-2009 financial crisis) and many companies. These study, however, was only limited to the crisis period. What kinds of spillovers are experienced when there are no financial crises? This requires further study while maintaining other assumptions of this research constant. Fonseca and Gottschalk analyzed volatility spillover effects between three variables, CDS spreads, realized volatility and stock returns, using the volatility measures based on a VAR model suggested by Diebold and Yilmaz (2011). The study revealed that realized volatility was the main cause of spillover effects among the three variables. However, the results of his study may vary if other sophisticated methods of quantifying the volatility measures. Otherwise, the method (VAR Model) used is easy to implement. Tang and Yang (2006) studied the effects of liquidity in the credit default swaps (CDS) markets and liquidity spillover from the other markets on CDS spreads. The study demonstrated how liquidity and liquidity spillover effects affects the CDS spreads. The study revealed that as the CDS market liquidity gets better, liquidity spillover effects reduces and become less significant. However, the relationships of these variables are still unclear and require further research. Zhu (2006) studied both short-term and long-term accuracy of pricing in the CDS market in relation to the bond market. He used the time series model. The study results indicated that deviation in the two markets was mainly caused by changes in credit conditions in relation to the behavior of the CDS spreads. Little research has been done on the sensitivities and spillover effects on CDS spreads from bond, equity and options markets. In the research considered in this report, options markets and equity markets could be the major contributors of spillover effects on CDS spreads during financial crises. Notable research has been done on liquidity and volatility spillover effects on the CDS markets (Gande &Parsley, 2005). 3.3 Credit Default Swaps in the context of monitoring sovereign risks in both developed and emerging market economies. Chen (2007) defines credit default swaps as “structured instruments which make an agreed payoff upon the occurrence of a credit event.” While Fonseca and Gottschalk (2012) explains that a credit default swap (CDS) as a “derivative contact” between two parties which insures against a credit event of an “underlying entity.” The protection seller and the protection buyer are bound by a contract which states how the protection seller will compensate the protection buyer if a credit event occurs before the maturity of the contract. Recent crisis experienced by developed countries and the emerging markets have increased the rate of the occurrence of default events (Stulz, 2004). Several studies have looked into this issue. An IMF paper (2005) looked into overpricing of sovereign bonds in emerging markets by CTD bond methodology to estimate the theoretical CDS spreads and compare them with market CDS spreads during distress in emerging markets. The paper relied on CDS quotes to compute the implied default probability.it would have been more reliable to use cash bond prices which are more accurate since CDS quotes may mispriced. The results of the study revealed that the credit events in the emerging markets were majorly as a result of restructuring and not necessarily an outright default. The study also predicted that the emerging markets will be able to manage such restructurings in a good manner, and that agreed settlements between creditors and debtors are likely to be more common. In case the bond prices collapse, there will be no need for restructuring during financial crises. Therefore, the results of this study only hold if the bond prices do not collapse during such periods of crisis. Fonseca and Gottschalk (2012) studied the co-movement of credit default swap spreads, stock market returns and volatilities by basing their evidence on the, well developed, Australian, Japanese, Korean and Hon Kong credit default swap (CDS) markets. The study focused on the relation between volatility (computed using high frequency data) and CDS spreads, among other variables. The results of this study indicated that at firm level, stocks returns lead the CDS, but at market level all assets affected the CDS. Though the results of this study agreed with previous studies on other markets, further studies need to be done on the emerging markets (IMF, 2005). CDS market development is of importance to the emerging market economies. It enables the investors to spread their risks such as default, market, foreign exchange, and interest rate risks, (Lando, 1998). This enhances the free flow of capital among countries and thus opening up more opportunities for the diversification of portfolios. Such portfolio diversification is important because emerging markets are known to be unstable (Kaminsky & Schmuckler, 2002). On the other hand, these developments have made some participants to manipulate the accounting information and evade the safeguards which are put in place. This could be caused by lack of comprehensive rules and regulations governing trade in the emerging markets. Weak internal controls within organizations may be considered as another contributor which should be addressed accordingly (Arezeki, Candelon, & Sy, 2010). 4.0 Recommendations Pricing of CDS spreads, which is vital in the determination of the CDS spreads, is still a challenge owing to the fact that changes of CDS spreads are non-linear and CDS quotes are obtained over the counter. CDS exchanges are supposed to be initiated so that CDS quotes used can be more accurate. A Market exchange centralizes all the market transactions and the market forces and thus CDS quotes obtained will be uniformed among all the participants in that market. In addition, development CDS market exchanges will attract more foreign investors leading to further portfolio diversification (Calice, Chen, & Williams, 2011). To curb risks associated with CDS markets, various countries have to come together and tackle the issue globally. Universal policies should be enacted to guide such markets and promote fair trade among different countries. By so doing, emerging markets will learn from the developed ones and might be able to gain stability thus competing fairly with their counterparts. Though increased rules and regulations may hinder trade in those markets, they are vital in terms of consistency and compensation in cases of credit events. Finally, comprehensive rules and regulations should be put in place to avoid vices witnessed in the emerging markets. These vices include manipulation of accounting information, deviance of rules and regulations of the markets, among others. Furthermore, the emerging economies which are said to be unstable should learn from the developed economies. This will help in building better CDS markets which are stable and are not likely to cause financial crises such as Euro zone debt crisis (Singh & Andritzky, 2003). References Arezeki, R., Candelon, B., & Sy, A., 2010. Sovereign Ratings News and Financial Markets Spillovers: Evidence from the European Debt Crisis. London: Cengage. Avino, D., Lazar, E., & Varotto, S., 2011. Which market drives credit spreads in tranquil and crisis periods? An analysis of the contribution of bonds, CDS, stocks and options. London: Cengage. Calice, G., Chen, J., & Williams, J., 2011. Liquidity Spillovers Sovereign Bond and CDS Markets: an analysis of the Eurozone Debt Crisis. London: Cengage. Chen, Y., 2007. What Explains Credit Default Swap Bid-Ask Spread? Dissertation And Theses Collection (Open Access), Paper 50. Diebold, X., & Yilmaz, K., 2009. Measuring Financial Asset Return and Volatility Spillovers, with Application to Global Equity Markets. Economic Journal, 119 (534), pp. 158-171. Driessen, J., 2005. Is default event risk priced in corporate bonds? Review of Financial Studies, 18, pp. 165-195. Dubey, R., 2010. An Alternate Approach to Determine Single Name CDS Spreads: Natural Extensions of the Merton Model of Corporate Default. Decision, 37. Duffie, D., & Singleton, K., 2003. Credit Risk: Pricing Measurement and Management. London: Princeton University Press. Fonseca, J., & Gottschalk, K., 2012. The Co-Movement Of Credit Default Swap Spreads, Stock Market Returns And Volatilities: Evidence From Asia-Pacific Markets. London: Cengage. Gande, A., & Parsley, D. C., 2005. News Spillovers in the Sovereign Debt Market. Journal of Financial Economics, 75 (3), pp. 691-734. Hull, J., & White, A., 2001. Valuing credit default swaps 1: No counterparty default risk. Journal of Derivatives, 8, pp. 29-40. Hull, J., 2007. Options, Futures and Other Derivatives. London: Pearson Education. IMF, 2005. The Role of Financial Derivatives in Emerging Markets. Washington: International Monetary Fund. Kaminsky, G., & Schmuckler, S. L., 2002. Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns? World Bank Economic Review, 16 (2), pp. 171-195. Lando, D., 1998. On Cox Processes and Credit Risky Securities. Review of Derivatives Research, 2, pp. 99–120. Singh, M., & Andritzky, G., 2003. Overpricing in Emerging Market Credit-Default-Swap Contracts: Some Evidence from Recent Distress Cases. IMF Working Paper 05/125 (Washington: International Monetary Fund). Stulz, R.M., 2004. Should we fear derivatives? Journal of Economic Perspectives, 18, p.173. Tang, D. Y., & Yan, H., 2006. Liquidity and Credit Default Swap Spreads. London: Pearson. Zhu, H., 2006. An Empirical Comparison of Credit Spreads between the Bond Market and the Credit Default Swap Market. Journal of Financial Services Research, 29, 211–235. Read More