Some determinants of the price of default risk

In this paper we study the pricing of credit risk as reflected in the market for credit default swaps (CDS) between 2003 and 2008. This market has newly emerged as the reference for credit risk pricing because of its use of standardized contract specifications and has achieved a higher level of liquidity than typically prevails in the markets for the underlying notes and bonds of the named corporate issuers. We initiate our exploration by studying a particular case which allows us to set out some of the issues of CDS pricing in a simple way. We show that for the purposes of accounting for relatively short-term changes of CDS spreads, an approach based on the structural (or firm-value based) models of credit risk faces an important obstacle in that reliable information about the firm’s liabilities required to calculate the “distance to default” are available only quarterly or in some cases annually. Thus structural models account for short-term movements in credit spreads largely by changes in the issuer’s equity price. In the case studied we show the effect of equity returns in explaining weekly changes of spreads is insignificant and of the wrong sign. In examination of particular episodes when the CDS spread was particularly delinked from the firm’s equity series, we find that a likely explanation is changes in expectations about the firm’s planned capital market operations. Since these are hard to capture in an observed proxy variable, we argued that this motivates the use of latent variable models that have recently been employed in the credit risk literature. We further see that movements in the CDS spreads for the particular name chosen are highly correlated with an index of CDS spreads for industrial Blue-chip names.