Component Structure of Credit Default Swap Spreads and Their Determinants
49 Pages Posted: 4 Sep 2008
Date Written: September 4, 2008
In this paper, we decompose credit default swap (CDS) spreads into a transitory component and a persistent component and test how these components are affected by the theoretical explanatory variables. We use three benchmark iTraxx Europe indices of two different maturities (5 and 10 years) and extract the components in the framework of Schwartz and Smith (2000). We then regress these components against proxies for several commonly used explanatory variables. We find significant but differing impacts of these explanatory variables on the extracted components. For example, equity volatility seems to have a larger influence on the transitory component, suggesting that its effect may be mostly short-lived, while our proxy for illiquidity has a bigger impact on the persistent component, which suggests that its effect is more enduring. Surprisingly, our proxy for the credit rating premium is not even significant in explaining two of the 10-year indices, but has a large effect on the persistent component. Finally, the slope of the yield curve has impacts with opposite signs on the two components and thus helps address the conflicting results reported in earlier studies without such a component framework. These results indicate that a two factor formulation, similar to Hull and White (1994) interest rate model, may be needed to model CDS options.
Keywords: Credit default swaps, Credit risk, Latent components, Kalman filter
JEL Classification: C11, C15, G12
Suggested Citation: Suggested Citation