Measuring Credit Risk: CDS Spreads vs. Credit Ratings
Posted: 12 Feb 2010
Date Written: February 11, 2010
The prices of or spread on credit default swaps (CDS) theoretically represent the pure credit risk of a firm. Callen, Livnat and Segal (2007) note that although the CDS premium is related to credit ratings issued by the rating agencies, rather wide variation in CDS spreads are observed for firms having a given rating. Following the recent subprime debacle, rating agencies have come under much scrutiny due to their role in the mispricing of credit risk and questions regarding the validity of the ratings that they issue are being questioned. This paper investigates the relationship between CDS spreads and credit ratings to help explain how market participants perceive and price credit risk. Using daily data obtained from Bloomberg on 391 five-year CDS contracts over the period 2003 to 2008, we model the credit default spreads as well as the variation between CDS spreads and credit ratings. Empirical results indicate that after controlling for market returns, market volatility and interest rates, CDS spreads increase with the subordination of the debt instrument, the put-implied volatility or deteriorating credit quality of the reference entity. We construct a credit quality variable derived from the quintiles of daily CDS spreads. Empirical results reveal statistically significant differences between credit ratings and our spread based credit quality variable. Observed discrepancies can be partly explained by stock market returns, levels of the VIX index, short-term and long-term interest rates as well as credit quality. However, empirical results indicate that a substantial share of the difference between credit ratings and CDS spreads cannot be attributed to either market or reference entity related variables.
Keywords: Credit Default Swaps, Credit Ratings, Recoveries, Default, Credit Risk
JEL Classification: G33, G34, C25, C15, C52
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