El bien jurídico protegido en los delitos contra la propiedad industrial

market spread

Credit default swap spreads are an interesting alternative to bond prices in empirical research on credit ratings for two reasons:

a. The CDS spread data provided via a broker consists of firm bid and offer quotes from dealers, once a quote has been made, the dealer is committed to trading a minimum principal ($10m) at the quoted price. On the other hand, the bond yield data usually consist of indications from dealers. There is no commitment from the dealer to trade at the specified price.

b. The second attraction of CDS spreads is that no adjustment is required - they are already credit spreads, whereas bond yields require an assumption about the appropriate benchmark risk-free rate before they can be converted into credit spreads, the usual practice of calculating the credit spread as the excess of the bond yield over a chosen risk-free benchmark.

Hull, Predescu, and White (2004)[41] examine the relationship between credit default swap spreads and bond yields and reach conclusions on the bench- mark risk-free rate by using a risk-free rate about 10 basis points less than the swap rate. They then carried out a series of tests to explore the extent to which credit rating announcements by Moody’s are anticipated by participants in the credit swap market.

An empirical comparison of credit spreads between the bond market and the CDS market is done by Zhu (2004)[77] on how the two markets interact with each other. He confirms the theoretical prediction that the two spreads should be on average equal to each other, however, in the short run, there are significant price discrepancies, which is largely due to their different responses to change in the credit quality of reference entities. He also finds that market participants seem to use swap rates rather than treasury rates as the proxy for risk-free rates, he shows the failure of treasury rates to be the proxy for risk-free rates could be largely attributed to tax considerations. Overall, the derivatives market seems to lead the cash market in anticipating rating events and in price adjustment. His empirical study also suggests that the relative importance of the two markets in price discovery can vary substantially across entity’s liquidity matters. There is also evidence of market segmentation in that U.S. entities behave very differently from those in other regions. Finally, he finds that the existence of a delivery option in CDS contracts and the short-sale restriction in the cash market only have minor impacts on credit risk pricing.

The swap rate is taken as the risk-free rate in Blance et al. (2003)[4], and they find credit default swap spreads to be quite close to bond yield spreads. They also find that the default swap market leads the bond market so that most price discovery occurs in the credit swap market. On the other hand, Houweling and Vorst (2005)[39] argue that market participants no longer see the treasury curve as the risk-free curve and instead use the swap curve and/or the repo curve, they confirm that the credit default swap market appears to use the swap rate rather than the treasury rate as the risk-free rate. The result of Hull et al. (2004)[41] is consistent with Vorst’s findings, they estimate that the market is using a risk-free rate about 10 basis points less than the swap rate to allow for the fact that the payoff does not reimburse the buyer of protection for accrued interest on bonds.

Elton et al. (2001)[27] decompose spot rates on corporate bonds into ex- pected loss, taxes and residual. They examine how much of the variation over

CHAPTER 2. LITERATURE REVIEW 40

time in the residual spread can be explained by systematic risk factors, and cal- culate a risk premium based on these contributions. The more recent paper by Driessen (2005)[20] employs different methods and data to further decompose spreads into taxes, risk premium and liquidity premium.

Attempting to explain the precise relationship between credit default spread and credit risk, Amato and Remolona (2003)[1] did a comparison study with Elton et al. (2001)[27] and Driessen (2005)[20], they argue that the answer to the credit spread puzzle might lie in the difficulty of diversifying default risk. They review existing evidence on the determinants of credit spreads, including the role of taxes, risk premia and liquidity premia. In the end they suggest that the spreads are largely a compensation for the risk of unexpected losses from default that are invariably present in corporate bond portfolios.

In Chapter 5, the main argument/development is based on the framework Longstaff et al. (2005)[58], who study default risk over instruments such as interest rate swaps or credit default swaps, and find that using repo curve or swap curve provides a better fit than treasury curves, however, they also ignore the impact of counterparty risk, i.e. insurance company, investment banks, or even hedge funds, whose own default is at risk. The reason swap rates, or say, LIBOR curve provides a good fit on CDS spreads fitting models, is that they both ignored the underlying counterparty default risk, which is embedded in both LIBOR rates and CDS prices. Longstaff et al. (2005)[58] also find there is a big difference between the spread obtained from the CDS market and spread generated by using bracketing bonds from the corporate bond market for the same underlying reference entity. They then state that counterparty risk cannot fully explain the difference between the spreads.

In Chapter 5, our model is developed to add counterparty spread onto CDS spreads from the market, by keeping the government bond rates as risk-free rate, we brought the counterparty-risk adjusted CDS spread onto the same platform as the spread generated by the bond market, and find much less difference between the two, which makes default risk a bigger component than previous

studies and liquidity risk count not as a big proportion of the total spread.