The Delivery Option in Credit Default Swaps

33 Pages Posted: 22 May 2006 Last revised: 26 Oct 2007

See all articles by Rainer Pullirsch

Rainer Pullirsch

Bank Austria Creditanstalt - Department of Operational and Group Risk Control

Tanja Veza

WU Vienna (Vienna University of Economics and Business)

Rainer Jankowitsch

WU (Vienna University of Economics and Business); Vienna Graduate School of Finance (VGSF)

Date Written: October 25, 2007

Abstract

Under standard assumptions the deterministic reduced-form credit risk model is not capable of accurately pricing the two fundamental credit risk instruments - bonds and credit default swaps (CDS) - simultaneously. Using a data set of euro-denominated corporate bonds and CDS our paper quantifies this mispricing by calibrating such a model to the bond data and subsequently using it to price CDS, resulting in model CDS spreads up to 50% lower on average than observed in the market. An extended model is presented which includes the delivery option implicit in CDS contracts emerging since a basket of bonds is deliverable in default. By using a constant recovery rate standard models assume equal recoveries for all bonds and hence zero value for the delivery option. Contradicting this common assumption, case studies of Chapter 11 filings presented in the paper show that corporate bonds do not trade at equal levels following default. Our extension models the implied expected recovery rate of the cheapest-to-deliver bond and, applied to the data, it largely eliminates the mispricing. The calibrated recovery values lie between 8% and 47% for different obligors, exhibiting strong variation among rating classes and industries. A cross-sectional analysis reveals that the implied recovery parameter depends on proxies for the delivery option, primarily the number of available bonds and the bond pricing errors. No evidence is found for a direct influence of the bid-ask spread, notional amount, coupon, or rating used as proxies for bond market liquidity.

Keywords: credit risk, default, corporate bond, credit default swap, reduced-form model, recovery rate, delivery option

JEL Classification: C13, G12, G13, G15

Suggested Citation

Pullirsch, Rainer and Veza, Tanja and Jankowitsch, Rainer, The Delivery Option in Credit Default Swaps (October 25, 2007). EFA 2007 Ljubljana Meetings Paper, Available at SSRN: https://ssrn.com/abstract=903713 or http://dx.doi.org/10.2139/ssrn.903713

Rainer Pullirsch

Bank Austria Creditanstalt - Department of Operational and Group Risk Control ( email )

Julius Tandler Platz 3
Vienna 1011
Austria

Tanja Veza

WU Vienna (Vienna University of Economics and Business) ( email )

Institute for Banking and Finance
Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria

Rainer Jankowitsch (Contact Author)

WU (Vienna University of Economics and Business) ( email )

Welthandelsplatz 1
Vienna, Vienna AT1020
Austria
+43 1 31 336 4340 (Phone)
+43 1 310 0580 (Fax)

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

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