Credit default swap index

About: Credit default swap index is a research topic. Over the lifetime, 2801 publications have been published within this topic receiving 108251 citations. The topic is also known as: CDS Index.

Credit Rationing in Markets with Imperfect Information.

Abstract: According to basic economics, if demand exceeds supply, prices will rise, thus decreasing demand or increasing supply until demand and supply are in equilibrium; thus if prices do their job, rationing will not exist. However, credit rationing does exist. This paper demonstrates that even in equilibrium, credit rationing will exist in a loan market. Credit rationing is defined as occurring either (a) among loan applicants who appear identical, and some do and do not receive loans, even though the rejected applicants would pay higher interest rates; or (b) there are groups who, with a given credit supply, cannot obtain loans at any rate, even though with larger credit supply they would. A model is developed to provide the first theoretical justification for true credit rationing. The amount of the loan and the amount of collateral demanded affect the behavior and distribution of borrowers. Consequently, faced with increased credit demand, it may not be profitable to raise interest rates or collateral; instead banks deny loans to borrowers who are observationally indistinguishable from those receiving loans. It is not argued that credit rationing always occurs, but that it occurs under plausible assumptions about lender and borrower behavior. In the model, interest rates serve as screening devices for evaluating risk. Interest rates change the behavior (serve as incentive mechanism) for the borrower, increasing the relative attractiveness of riskier projects; banks ration credit, rather than increase rates when there is excess demand. Banks are shown not to increase collateral as a means of allocating credit; although collateral may have incentivizing effects, it may have adverse selection effects. Equity, nonlinear payment schedules, and contingency contracts may be introduced and yet there still may be rationing. The law of supply and demand is thus a result generated by specific assumptions and is model specific; credit rationing does exist. (TNM)

Modeling Term Structures of Defaultable Bonds

Abstract: This article presents convenient reduced-form models of the valuation of contingent claims subject to default risk, focusing on applications to the term structure of interest rates for corporate or sovereign bonds. Examples include the valuation of a credit-spread option. This article presents a new approach to modeling term structures of bonds and other contingent claims that are subject to default risk. As in previous “reduced-form” models, we treat default as an unpredictable event governed by a hazard-rate process. 1 Our approach is distinguished by the parameterization of losses at default in terms of the fractional reduction in market value that occurs at default. Specifically, we fix some contingent claim that, in the event of no default, pays X at time T . We take as given an arbitrage-free setting in which all securities are priced in terms of some short-rate process r and equivalent martingale measure Q [see Harrison and Kreps (1979) and Harrison and Pliska (1981)]. Under this “risk-neutral” probability measure, we letht denote the hazard rate for default at time t and let Lt denote the expected fractional loss in market value if default were to occur at time t , conditional

Pricing Derivatives on Financial Securities Subject to Credit Risk

Abstract: This article provides a new methodology for pricing and hedging derivative securities involving credit risk. Two types of credit risks are considered. The first is where the asset underlying the derivative security may default. The second is where the writer of the derivative security may default. We apply the foreign currency analogy of Jarrow and Turnbull (1991) to decompose the dollar payoff from a risky security into a certain payoff and a "spot exchange rate." Arbitrage-free valuation techniques are then employed. This methodology can be applied to corporate debt and over the counter derivatives, such as swaps and caps. THE PURPOSE OF THIS article is to provide a new theory for pricing and hedging derivative securities involving credit risk. Two sources of credit risk are identified and analyzed. The first is where the asset underlying the derivative security may default, paying off less than promised. This is the case, for example, with imbedded options on corporate debt. The second is the credit risk introduced by the writer of the derivative security, who may also default. Examples include over-the-counter writers of options on Eurodollar futures, swaps, and swaptions. For pricing derivative securities involving credit risk, there are currently two approaches. The first views these derivatives as contingent claims not on the financial securities themselves, but as "compound options" on the assets underlying the financial securities. This is the case, for example, with the pricing of imbedded options on corporate debt (see Merton (1974, 1977), Black and Cox (1976), Ho and Singer (1982), Chance (1990), and Kim, Ramaswamy, and Sundaresan (1993)) or the pricing of vulnerable options (see Johnson and Stulz (1987)). In practice, however, this valuation methodology is difficult to use. First, the assets underlying the financial security are often not tradeable and therefore their values are not observable. This makes application of the theory and estimation of the relevant parameters problematic. Second, as in the case of corporate debt, all of the other liabilities of the firm senior to the corporate debt must first (and simultaneously) be valued. This generates significant computational difficulties. As a result, this approach has not

Forecasting Default with the Merton Distance to Default Model

Abstract: We examine the accuracy and contribution of the Merton distance to default (DD) model, which is based on Merton's (1974) bond pricing model. We compare the model to a “naive” alternative, which uses the functional form suggested by the Merton model but does not solve the model for an implied probability of default. We find that the naive predictor performs slightly better in hazard models and in out-of-sample forecasts than both the Merton DD model and a reduced-form model that uses the same inputs. Several other forecasting variables are also important predictors, and fitted values from an expanded hazard model outperform Merton DD default probabilities out of sample. Implied default probabilities from credit default swaps and corporate bond yield spreads are only weakly correlated with Merton DD probabilities after adjusting for agency ratings and bond characteristics. We conclude that while the Merton DD model does not produce a sufficient statistic for the probability of default, its functional form is useful for forecasting defaults.

Default Risk in Equity Returns

Abstract: This is the first study that uses Merton's (1974) option pricing model to compute default measures for individual firms and assess the effect of default risk on equity returns. The size effect is a default effect, and this is also largely true for the book-to-market (BM) effect. Both exist only in segments of the market with high default risk. Default risk is systematic risk. The Fama-French (FF) factors SMB and HML contain some default-related information, but this is not the main reason that the FF model can explain the cross-section of equity returns.