Abstract
Correlated default factors and systemic risk are clearly priced in credit portfolio securities such as CDOs or index CDSs. In this paper we study an extensive CDX data set for evidence of whether correlated default factors are also present in the underlying CDS market. We develop a cash-flow-based top-down approach for modeling CDSs from which we can derive the following major contributions: (1) Correlated default factors did not matter for CDS prices prior to the financial crisis in 2008. During and after the crisis, however, their importance increased strongly. (2) We observe that correlated default factors primarily impact on the CDS prices of firms with an overall low CDS level. (3) Idiosyncratic risk factors for each single CDS play a major (minor) role when the CDS premia are high (low).
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
The index CDS can be considered as a tranche on the whole portfolio interval 0–1.
The facts also hold for CDS model premia.
Descriptive statistics for the pre-crisis, crisis and post-crisis periods are reported in the “Appendix”.
Descriptive statistics for the pre-crisis, crisis and post-crisis periods are reported in the “Appendix”.
Or even less than \(0\,\%\). In that rare case, two single names default if the first factor jumps.
References
Arnsdorf, M., & Halperin, I. (2009). BSLP: Markovian bivariate spread-loss model for portfolio credit derivatives. Journal of Computational Finance, 12, 77–107.
Bielecki, T. R., Crépey, S., & Jeanblanc, M. (2010). Up and down credit risk. Quantitative Finance, 10, 1137–1151.
Brigo, D., Pallavicini, A., & Torresetti, R. (2010). Credit models and the crisis: A journey into CDOs, copulas,correlations and dynamic models. West Sussex, UK: Wiley Finance.
Cox, J. C., Ingersoll, J. E., & Ross, S. A. (1985). A theory of the term structure of interest rates. Econometrica, 53, 385–408.
Das, S. R., Duffie, D., Kapadia, N., & Saita, L. (2007). Common failings: How corporate defaults are correlated. Journal of Finance, 62, 93–117.
Ding, X., Giesecke, K., & Tomecek, P. I. (2009). Time-changed birth processes and multiname credit derivatives. Operations Research, 57, 990–1005.
Duffie, D., Saita, L., & Wang, K. (2007). Multi-period corporate default prediction with stochastic covariates. Journal of Financial Economics, 83, 635–665.
Duffie, D., Eckner, A., Horel, G., & Saita, L. (2009). Frailty correlated default. Journal of Finance, 64, 2089–2123.
Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance, 47, 427–465.
Feldhütter, P., & Nielsen, M. S. (2012). Systematic and idiosyncratic default risk in synthetic credit markets. Journal of Financial Econometrics, 10, 292–324.
Gallant, A. R. (1975). Nonlinear regression. The American Statistician, 29, 73–81.
Giesecke, K., Goldberg, L. R., & Ding, X. (2011). A top-down approach to multiname credit. Operations Research, 59, 283–300.
Gürkaynak, R. S., Sack, B., & Wright, J. H. (2006). The U.S. Treasury yield curve: 1961 to the present, Finance and Economics Discussion Series. Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, DC.
Hull, J., & White, A. (2004). Valuation of a CDO and an \(n{\rm th}\) to default CDS without Monte Carlo simulation. Journal of Derivatives, 12, 8–23.
Junge, B., & Trolle, A. B. (2015). Liquidity risk in credit default swap markets, Swiss Finance Institute, Working Paper.
Kahle, K. M., & Stulz, R. M. (2010). Financial policies and the financial crisis: How important was the systemic credit contraction for industrial corporations? NBER Working Paper Series.
Lando, D. (1998). On Cox processes and credit risky securities. Review of Derivatives Research, 2, 99–120.
Li, D. X. (2000). On default correlation: A copula function approach. Journal of Fixed Income, 9, 43–54.
Longstaff, F. A., & Rajan, A. (2008). An empirical analysis of the pricing of collateralized debt obligations. Journal of Finance, 63, 529–563.
Longstaff, F. A., Mithal, S., & Neis, E. (2005). Corporate yield spreads: Default risk or liquidity? New evidence from the credit default swap market. Journal of Finance, 60, 2213–2253.
Lopatin, A. V. (2011). A simple dynamic model for pricing and hedging heterogeneous CDOs. In T. R. Bielecki, D. Brigo, & F. Patras (Eds.), Credit risk frontiers, chap 4 (1st ed., pp. 71–103). Hoboken, NJ, USA: Wiley.
Meine, C., Supper, H., & Weiß, G. N. F. (2014). Is tail risk priced in credit default swap premia? University of Dortmund, Working Paper.
Schönbucher, P. J. (2005). Portfolio losses and the term structure of loss transition rates: A new methodology for the pricing of Portfolio credit derivatives, ETH Zurich, Working Paper.
Author information
Authors and Affiliations
Corresponding author
Additional information
We have benefited from comments by Peter Raupach, Niels Schulze, participants of the Deutsche Bundesbank Research Seminar and an anonymous referee. This paper represents the authors’ personal opinions and does not necessarily reflect the views of the Deutsche Bundesbank or its staff.
Appendix
Appendix
See Tables 5, 6, 7, 8, 9 and 10.
Rights and permissions
About this article
Cite this article
Koziol, C., Koziol, P. & Schön, T. Do correlated defaults matter for CDS premia? An empirical analysis. Rev Deriv Res 18, 191–224 (2015). https://doi.org/10.1007/s11147-015-9109-4
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11147-015-9109-4
Keywords
- Correlated defaults
- Systemic risk
- Idiosyncratic risk
- Collateralized debt obligations
- Credit default swaps
- Credit derivatives