On Pricing Credit Default Swaps with Observable Covariates

49 Pages Posted: 2 Jul 2011 Last revised: 16 Mar 2012

See all articles by Hitesh Doshi

Hitesh Doshi

University of Houston - C.T. Bauer College of Business

Jan Ericsson

McGill University; Swedish Institute for Financial Research (SIFR)

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business

Date Written: June 7, 2011

Abstract

Observable covariates are useful for predicting default under the natural measure, but several findings question their value for explaining credit spreads under the pricing measure. We introduce a discrete time no-arbitrage model with observable covariates, which allows for a closed form solution for the value of credit default swaps (CDS). The default intensity is a quadratic function of the covariates, specified such that it is always positive. The model yields economically sensible results in terms of fit, economic impact of coefficients, and statistical significance. Macroeconomic and firm-specific information can explain most of the variation in CDS spreads over time and across firms, even with a parsimonious specification. These findings resolve the existing disconnect in the literature regarding the value of observable covariates for credit risk pricing and default prediction. Our results also suggest that although CDS spreads are highly auto-correlated, analyzing spread levels may be preferable to analyzing differences for daily CDS data.

Keywords: credit default swap, no-arbitrage, observable covariates, volatility, leverage, distance-to-default

JEL Classification: G12

Suggested Citation

Doshi, Hitesh and Ericsson, Jan and Jacobs, Kris and Turnbull, Stuart M., On Pricing Credit Default Swaps with Observable Covariates (June 7, 2011). Available at SSRN: https://ssrn.com/abstract=1784962 or http://dx.doi.org/10.2139/ssrn.1784962

Hitesh Doshi

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Jan Ericsson

McGill University ( email )

1001 Sherbrooke St. West
Montreal, Quebec H3A1G5 H3A 2M1
Canada
(514) 398-3186 (Phone)
(514) 398-3876 (Fax)

HOME PAGE: http://people.mcgill.ca/jan.ericsson/

Swedish Institute for Financial Research (SIFR)

Drottninggatan 89
SE-113 59 Stockholm, SE-113 60
Sweden

Kris Jacobs (Contact Author)

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Stuart M. Turnbull

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

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