Spread Risk Premia in Corporate Credit Default Swap Markets

Abstract

The spread risk premium component of credit default swap (CDS) spreads represents a compensation demanded by protection sellers for future changes in CDS spreads caused by unpredictable fluctuations in the reference entity’s risk-neutral default intensity. This paper defines and estimates a measure of the spread risk premium component in CDS spreads of a sample of European investment-grade firms by using a stochastic intensity credit model. Our results show that, on average, investors demand a positive premium for such mark-to-market risks. After controlling for CDS market conditions, like liquidity and supply/demand effects, a panel data analysis of the estimated spread risk premia reveals among other things a significant positive impact of event risk captured by the overall stock market volatility and of investors’ appetite for exposure to credit markets as reflected by the overall CDS market.

Keywords: credit default swap, default risk premium, default event risk premium, spread risk premium, mark-to-market risk premium, stochastic intensity model

JEL Classification: G12, G13, G15