The Signalling Properties of the Shape of the Credit Default Swap Term Structure

30 Pages Posted: 29 Jun 2016

See all articles by Jenny Castellanos

Jenny Castellanos

University of Essex - Centre for Computational Finance and Economic Agents

Nick Constantinou

University of Essex - Essex Business School

Wing Lon Ng

Bounded Rationality Advancement in Computational Intelligence Laboratory (BRACIL)

Date Written: April 24, 2015

Abstract

This paper studies the predictive power of the time-varying shape of the credit default swap (CDS) term structure to explain changes in future implied and excess implied volatility (implied volatility of the company over and above the market volatility) and therefore provide a leading sign of potential financial distress in a company. The shape of the CDS curve is captured by fitting the Nelson-Siegel model to the term structure and creating a new binary indicator (shape indicator) to distinguish between "good" and "bad" CDS curves. Applying the methodology to twenty US-traded companies from the financial and non-financial sectors, we find that the credit market is generally a leading indicator for movements in the volatility market during the subprime crisis. After confirming the strong link between CDSs and implied volatility markets (the average R2 per sector between 36% and 63% is obtained using the Nelson-Siegel parameter and shape indicator), a partial F -test is executed to see if additional information is contained within the CDS markets over and above the volatility markets. For the period studied, this is the case for the majority of names, and it is particularly significant for Lehman Brothers.

Keywords: credit risk, CDS term structure, Nelson–Siegel, implied volatility

Suggested Citation

Castellanos, Jenny and Constantinou, Nick and Ng, Wing Lon, The Signalling Properties of the Shape of the Credit Default Swap Term Structure (April 24, 2015). Journal of Risk, Vol. 17, No. 4, 2015, Available at SSRN: https://ssrn.com/abstract=2799645

Jenny Castellanos (Contact Author)

University of Essex - Centre for Computational Finance and Economic Agents ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

Nick Constantinou

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester, Essex CO4 3SQ
United Kingdom

Wing Lon Ng

Bounded Rationality Advancement in Computational Intelligence Laboratory (BRACIL) ( email )

United Kingdom

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