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An Empirical Comparison of Default Swap Pricing Models

Author

Listed:
  • Patrick Houweling

    (Erasmus University Rotterdam & Rabobank International)

  • Ton Vorst

    (Erasmus University Rotterdam & ABN Amro)

Abstract

In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model with a constant recovery rate outperforms the market practice of directly comparing bonds' credit spreads to default swap premiums. We find that the model works well for investment grade credit default swaps, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is insensitive to the value of the assumed recovery rate

Suggested Citation

  • Patrick Houweling & Ton Vorst, 2001. "An Empirical Comparison of Default Swap Pricing Models," Finance 0112003, University Library of Munich, Germany.
    • Handle: RePEc:wpa:wuwpfi:0112003
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    Cited by:

    1. Jaewon Choi & Or Shachar, 2013. "Did liquidity providers become liquidity seekers?," Staff Reports 650, Federal Reserve Bank of New York.
    2. Marat Kurbangaleev & Victor Lapshin & Sergey N. Smirnov, 2015. "Study of Consistency of Bond and CDS Quotes," HSE Working papers WP BRP 43/FE/2015, National Research University Higher School of Economics.
    3. Martin Scheicher, 2003. "Credit Derivatives - Overview and Implications for Monetary Policy and Financial Stability," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 5, pages 96-111.
    4. Kiff, J. & Michaud, F L. & Mitchell, J., 2003. "An analytical review of credit risk tranfer instruments," Financial Stability Review, Banque de France, issue 2, pages 106-131, June.
    5. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
    6. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
    7. da Silva, Paulo Pereira & Rebelo, Paulo Tomaz & Afonso, Cristina, 2014. "Tail dependence of financial stocks and CDS markets: Evidence using copula methods and simulation-based inference," Economics - The Open-Access, Open-Assessment E-Journal (2007-2020), Kiel Institute for the World Economy (IfW Kiel), vol. 8, pages 1-27.
    8. Calice, Giovanni & Ioannidis, Christos, 2012. "An empirical analysis of the impact of the credit default swap index market on large complex financial institutions," International Review of Financial Analysis, Elsevier, vol. 25(C), pages 117-130.
    9. Clemens Kool, 2006. "Financial Stability in European Banking: The Role of Common Factors," Open Economies Review, Springer, vol. 17(4), pages 525-540, December.
    10. Haibin Zhu, 2004. "An empirical comparison of credit spreads between the bond market and the credit default swap market," BIS Working Papers 160, Bank for International Settlements.
    11. Nicholas Apergis & Emmanuel Mamatzakis, 2014. "What are the driving factors behind the rise of spreads and CDS of euro-area sovereign bonds? A FAVAR model for Greece and Ireland," International Journal of Economics and Business Research, Inderscience Enterprises Ltd, vol. 7(1), pages 104-120.
    12. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer;Western Finance Association, vol. 26(2), pages 161-191, October.
    13. Gori, Filippo, 2018. "Dissecting the ‘doom loop’: the bank-sovereign credit risk nexus during the US debt ceiling crisis," MPRA Paper 87994, University Library of Munich, Germany.
    14. Hoi Wong & Tsz Wong, 2007. "Reduced-form Models with Regime Switching: An Empirical Analysis for Corporate Bonds," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 14(3), pages 229-253, September.
    15. Didier Cossin & Hongze Lu, 2005. "Are European Corporate Bond and Default Swap Markets Segmented?," FAME Research Paper Series rp133, International Center for Financial Asset Management and Engineering.
    16. Abel Elizalde, 2006. "Credit Risk Models I: Default Correlation in Intensity Models," Working Papers wp2006_0605, CEMFI.
    17. Lekkos, Ilias, 2007. "Modelling multiple term structures of defaultable bonds with common and idiosyncratic state variables," Journal of Empirical Finance, Elsevier, vol. 14(5), pages 783-817, December.
    18. Norden, Lars & Weber, Martin, 2004. "Informational efficiency of credit default swap and stock markets: The impact of credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2813-2843, November.
    19. Norden, Lars & Weber, Martin, 2004. "The comovement of credit default swap, bond and stock markets: An empirical analysis," CFS Working Paper Series 2004/20, Center for Financial Studies (CFS).
    20. Roberto Blanco & Simon Brennan & Ian W Marsh, 2004. "An empirical analysis of the dynamic relationship between investment-grade bonds and credit default swaps," Bank of England working papers 211, Bank of England.
    21. Didier Cossin & Tomas Hricko & Daniel Aunon-Nerin & Zhijiang Huang, 2002. "Exploring for the Determinants of Credit Risk in Credit Default Swap Transaction Data: Is Fixed-Income Markets’ Information Suffcient to Evaluate Credit Risk?," FAME Research Paper Series rp65, International Center for Financial Asset Management and Engineering.
    22. Linda Allen & Anthony Saunders, 2003. "A survey of cyclical effects in credit risk measurement model," BIS Working Papers 126, Bank for International Settlements.
    23. Benbouzid, Nadia & Mallick, Sushanta & Pilbeam, Keith, 2018. "The housing market and the credit default swap premium in the UK banking sector: A VAR approach," Research in International Business and Finance, Elsevier, vol. 44(C), pages 1-15.

    More about this item

    Keywords

    credit default swaps; credit derivatives; credit risk; default risk; risk-neutral valuation; pricing;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General

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