What Determines Euro Area Bank CDS Spreads?
Antwerp Management School; University of Antwerp - Faculty of Applied Economics
Marc J. K. De Ceuster
University of Antwerp - Faculty of Applied Economics - City Campus
Patrick Van Roy
National Bank of Belgium
affiliation not provided to SSRN
May 10, 2010
National Bank of Belgium Working Paper No. 190
This paper decomposes the explained part of the CDS spread changes of 31 listed euro area banks according to various risk drivers. The choice of the credit risk drivers is inspired by the Merton (1974) model. Individual CDS liquidity and other market and business variables are identified to complement the Merton model and are shown to play an important role in explaining credit spread changes. Our decomposition reveals, however, highly changing dynamics in the credit, liquidity, and business cycle and market wide components. This result is important since supervisors and monetary policy makers extract different signals from liquidity based CDS spread changes than from business cycle or credit risk based changes. For the recent financial crisis, we confirm that the steeply rising CDS spreads are due to increased credit risk. However, individual CDS liquidity and market wide liquidity premia played a dominant role. In the period before the start of the crisis, our model and its decomposition suggest that credit risk was not correctly priced, a finding which was correctly observed by e.g. the International Monetary Fund.
Number of Pages in PDF File: 38
Keywords: credit default spreads, credit risk, financial crisis, financial sector, liquidity premia, structural model
JEL Classification: G01, G12, G21Accepted Paper Series
Date posted: September 23, 2010 ; Last revised: September 27, 2010
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