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Exploring for the Determinants of Credit Risk in Credit Default Swap Transaction Data

Credit risk has received much attention in the academic literature. The bulk of the work has focused on theoretical valuation issues. There is far less research on the empirical side. Nearly all of the empirical work investigating credit risk has focused on the bond market. The main approach was to explain the determinants and the dynamics of the credit spread, hence the difference between the yield on a bond of a risky counterparty and a government bond. Government and corporate bonds differ in a variety of ways, which makes the credit spread an imperfect proxy for credit risk. Some of the issues are addressed in Duffee (1998).

Financial innovation has led to the emergence of a new kind of derivative written directly on a credit risk, credit derivatives. The Credit Default Swap (CDS) is the most used Credit Derivative. A Credit Default Swap is an instrument that provides its buyer with a lump sum payment made by the seller in the case of default (or other ” credit event ”) of an underlying reference entity against the periodic payment made by the buyer. This periodic payment expressed as a function of its notional value is the CDS rate.

No academic study that we know of has investigated the empirical behavior of credit default swap rates. Such a study has strong implications for our understanding of credit risk behavior. It represents an opportunity to study credit risk from another instrument than the fixed income instruments (bonds, swaps) analyzed previously.

We test for the influence of the theoretical factors predicted by the reduced and the structural form literature. Moreover, we test for the stability of the influences by using a cross-section of credit default swap rates on a variety of underlyings.

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Exploring for the Determinants of Credit Risk in Credit Default Swap Transaction Data