Exploring Mispricing in the Term Structure of CDS Spreads

Forthcoming, Review of Finance

104 Pages Posted: 6 Nov 2015 Last revised: 19 Mar 2018

See all articles by Robert A. Jarrow

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management

Haitao Li

Cheung Kong Graduate School of Business

Xiaoxia Ye

University of Liverpool Management School

May Hu

Deakin University

Date Written: March 13, 2018

Abstract

Based on a reduced-form model of credit risk, we explore mispricing in the CDS spreads of North American companies and its economic content. Specifically, we develop a trading strategy using the model to trade out of sample market-neutral portfolios across the term structure of CDS contracts. Our empirical results show that the trading strategy exhibits abnormally large returns, confirming the existence and persistence of a mispricing. The aggregate returns of the trading strategy are positively related to the square of market-wide credit and liquidity risks, indicating that the mispricing is more pronounced when the market is more volatile. When implemented on the Markit data, the strategy shows significant economic value even after controlling for realistic transaction costs.

Keywords: Credit default swaps, mispricing, statistical arbitrage, affine models, market-neutral strategy, hedge funds

JEL Classification: G11, G12, G13, G14

Suggested Citation

Jarrow, Robert A. and Li, Haitao and Ye, Xiaoxia and Hu, May, Exploring Mispricing in the Term Structure of CDS Spreads (March 13, 2018). Forthcoming, Review of Finance. Available at SSRN: https://ssrn.com/abstract=2686284 or http://dx.doi.org/10.2139/ssrn.2686284

Robert A. Jarrow

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Department of Finance
Ithaca, NY 14853
United States
607-255-4729 (Phone)
607-254-4590 (Fax)

Haitao Li

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Xiaoxia Ye (Contact Author)

University of Liverpool Management School ( email )

Chatham Street
Liverpool, L69 7ZH
United Kingdom

May Hu

Deakin University ( email )

Graduate School of Business
Melbourne, Victoria 3125
Australia

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