Measuring Credit Risk: CDS Spreads vs. Credit Ratings

Posted: 12 Feb 2010

See all articles by Ahmet K Karagozoglu

Ahmet K Karagozoglu

Hofstra University, Zarb School of Business

Michael Jacobs

Accenture Consulting

Date Written: February 11, 2010

Abstract

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

Suggested Citation

Karagozoglu, Ahmet K and Jacobs, Michael, Measuring Credit Risk: CDS Spreads vs. Credit Ratings (February 11, 2010). Available at SSRN: https://ssrn.com/abstract=1551406

Ahmet K Karagozoglu (Contact Author)

Hofstra University, Zarb School of Business ( email )

Department of Finance
134 Hofstra University
Hempstead, NY 11549
United States
(516) 463-5701 (Phone)
(718) 701-8331 (Fax)

HOME PAGE: http://people.hofstra.edu/ahmet_k_karagozoglu/

Michael Jacobs

Accenture Consulting ( email )

1345 Avenue of the Americas
New York, NY 10105
United States
9173242098 (Phone)

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