Component Structure of Credit Default Swap Spreads and Their Determinants

49 Pages Posted: 4 Sep 2008

See all articles by Ramaprasad Bhar

Ramaprasad Bhar

UNSW Business School, Risk and Actuarial Studies

David B. Colwell

UNSW Australia Business School, School of Banking and Finance; Financial Research Network (FIRN)

Peipei Wang

Deakin University

Multiple version iconThere are 2 versions of this paper

Date Written: September 4, 2008

Abstract

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

Bhar, Ramaprasad and Colwell, David B. and Wang, Peipei, Component Structure of Credit Default Swap Spreads and Their Determinants (September 4, 2008). 21st Australasian Finance and Banking Conference 2008 Paper. Available at SSRN: https://ssrn.com/abstract=1263176 or http://dx.doi.org/10.2139/ssrn.1263176

Ramaprasad Bhar (Contact Author)

UNSW Business School, Risk and Actuarial Studies ( email )

Sydney, NSW 2052
Australia

David B. Colwell

UNSW Australia Business School, School of Banking and Finance ( email )

Sydney, NSW 2052
Australia
+61 (2) 9385 5851 (Phone)
+61 (2) 9385 6347 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Peipei Wang

Deakin University ( email )

75 Pigdons Road
Victoria, Victoria 3216
Australia
61-03-92446906 (Phone)

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