This project discusses the intensity and survival probability derived from Credit Default Swaps (CDS). We utilize two models, the reduced intensity model and the Shift Square Root Diffusion (SSRD) model. In the reduced intensity model, we assume a deterministic intensity and implement a computer simulation to derive the survival probability and intensity from the CDS market quotes of the company. In the SSRD model, the interest rate and intensity are both stochastic and correlated. We discuss the impaction of correlation on the interest rate and intensity. We also conduct a Monte Carlo simulation to determine the dynamics of stochastic interest rate and intensity.

This master thesis discusses alternative debt management instruments - GDP-linked bonds. It provides concise characterization of sovereign debt management. Additionally, it discusses traditional derivatives, such as futures, swaps and bonds, from the government's point of view. The main goal of the thesis is to verify whether GDP-linked bonds are suitable for the Czech and Slovak debt management. Ergo, the bonds could smooth the cost of serving the debt. Furthermore, it describes the development of the sovereign debt and risk premium of the government bonds of the Czech and Slovak republics. It tries to find out whether the risk premium of Slovak bonds differed after introduction of euro. Additionally, the thesis analyzes the effect of various country specific variables on the development of the risk premium. The last but not least goal is to support or reject the hypothesis whether the GDP-linked bonds should be appealing to European economic and monetary union as the members has to satisfied Stability and Growth Pact requirements. The conclusion of the thesis is that the hypothesis of positive effect of the GDP-linked bonds on the cost of serving debt is partly rejected in case of the Czech and Slovak republics as well as in the case of European economic and monetary union. Furthermore, the risk...

The focus of this dissertation is the European Credit Default Swaps (CDSs) market. CDSs are the most popular credit derivative products. Three issues are discussed, the first, which is covered in chapter 2, is the investigation of non-diversifiable jump risk in iTraxx sector indices based on a multivariate model that explicitly admits discrete common jumps for an index and its components. Our empirical research shows that both the iTraxx Non-Financials and their components experience jumps during the sample period, which means that the jump risks in the iTraxx sector index are not diversifiable. The second issue, which is covered in chapter 3 is the component structure of credit default swap spreads and their determinants. We firstly extract a transitory component and a persistent component from two different maturities of the Markit iTraxx index and then regress these components against proxies for several commonly used explanatory variables. Our results show that these explanatory variables have significant but differing impacts on the extracted components, which indicates that a two-factor formulation may be needed to model CDS options. The last issue, which is covered in chapters 4, 5 and 6 is the investigation of the linkage between the credit default swap market and the equity market within the European area. We innovatively calibrate the CDS option with the Heston Model to get the implied volatility in the CDS market, which allows us to investigate both the characteristic of implied volatility in the CDS market and the relationship of the two markets not only on the level of daily changes but also with regard to its second moment. Our analysis shows that the stock market weakly leads the CDS market on daily changes but for implied volatility, the stock market leads the CDS market. A VECM analysis shows that only the stock market contributes to price discovery. For sub-investment grade entities, the interactivities between the implied volatility of the CDS market and the implied volatility of the stock market are stronger, especially during the recent credit crunch period. All these results have important implications for the construction of portfolios with credit-sensitive instruments.

This thesis is a collection of three essays in empirical studies on derivatives. In the first chapter, I investigate whether credit default swap spreads are affected by how the total risk is decomposed into the systematic risk and the idiosyncratic risk for a given level of the total risk. The risk composition is measured by the systematic risk proportion, defined as the proportion of the systematic variance in the total variance. I find that a firm’s systematic risk proportion has a negative and significant effect on its CDS spreads. Moreover, this empirical finding is robust to various alternative specifications and estimations. Therefore, the composition of the total risk is an important determinant of CDS spreads. In the second chapter, I estimate the illiquidity premium in the CDS spreads based on Jarrow’s illiquidity-modified Merton model using the transformed-data maximum likelihood estimation method. I find that the average model implied CDS illiquidity premium is about 15 basis points, accounting for 12% of the average level of the CDS spread. I further investigate how this parameter is affected by CDS liquidity measures such as the percentage bid-ask spread and the number of daily CDS spreads available in one month. I find that both liquidity measures are significant determinants of the model implied CDS illiquidity premium. In terms of relative importance, the bid-ask spread is more important than the number of daily CDS spreads statistically and economically. In the third chapter, I investigate the impact of the systematic risk on the volatility spread, i.e, the difference between the risk-neutral volatility and the physical volatility. I find that the systematic risk proportion of an underlying asset has a positive and significant impact on its volatility spread. The risk-neutral volatility in this study is measured with the increasingly popular approach known as the model-free risk-neutral volatility. The surprising positive systematic risk effect was first documented in Duan and Wei (2009) using the Black-Scholes implied volatility. I show that this effect is actually more prominent using the clearly better model-free risk-neutral volatility measure.

This thesis is a collection of three essays in empirical studies on derivatives. In the first chapter, I investigate whether credit default swap spreads are affected by how the total risk is decomposed into the systematic risk and the idiosyncratic risk for a given level of the total risk. The risk composition is measured by the systematic risk proportion, defined as the proportion of the systematic variance in the total variance. I find that a firm’s systematic risk proportion has a negative and significant effect on its CDS spreads. Moreover, this empirical finding is robust to various alternative specifications and estimations. Therefore, the composition of the total risk is an important determinant of CDS spreads. In the second chapter, I estimate the illiquidity premium in the CDS spreads based on Jarrow’s illiquidity-modified Merton model using the transformed-data maximum likelihood estimation method. I find that the average model implied CDS illiquidity premium is about 15 basis points, accounting for 12% of the average level of the CDS spread. I further investigate how this parameter is affected by CDS liquidity measures such as the percentage bid-ask spread and the number of daily CDS spreads available in one month. I find that both liquidity measures are significant determinants of the model implied CDS illiquidity premium. In terms of relative importance, the bid-ask spread is more important than the number of daily CDS spreads statistically and economically. In the third chapter, I investigate the impact of the systematic risk on the volatility spread, i.e, the difference between the risk-neutral volatility and the physical volatility. I find that the systematic risk proportion of an underlying asset has a positive and significant impact on its volatility spread. The risk-neutral volatility in this study is measured with the increasingly popular approach known as the model-free risk-neutral volatility. The surprising positive systematic risk effect was first documented in Duan and Wei (2009) using the Black-Scholes implied volatility. I show that this effect is actually more prominent using the clearly better model-free risk-neutral volatility measure.

The focus of this dissertation is the European Credit Default Swaps (CDSs) market. CDSs are the most popular credit derivative products. Three issues are discussed, the first, which is covered in chapter 2, is the investigation of non-diversifiable jump risk in iTraxx sector indices based on a multivariate model that explicitly admits discrete common jumps for an index and its components. Our empirical research shows that both the iTraxx Non-Financials and their components experience jumps during the sample period, which means that the jump risks in the iTraxx sector index are not diversifiable. The second issue, which is covered in chapter 3 is the component structure of credit default swap spreads and their determinants. We firstly extract a transitory component and a persistent component from two different maturities of the Markit iTraxx index and then regress these components against proxies for several commonly used explanatory variables. Our results show that these explanatory variables have significant but differing impacts on the extracted components, which indicates that a two-factor formulation may be needed to model CDS options. The last issue, which is covered in chapters 4, 5 and 6 is the investigation of the linkage between the credit default swap market and the equity market within the European area. We innovatively calibrate the CDS option with the Heston Model to get the implied volatility in the CDS market, which allows us to investigate both the characteristic of implied volatility in the CDS market and the relationship of the two markets not only on the level of daily changes but also with regard to its second moment. Our analysis shows that the stock market weakly leads the CDS market on daily changes but for implied volatility, the stock market leads the CDS market. A VECM analysis shows that only the stock market contributes to price discovery. For sub-investment grade entities, the interactivities between the implied volatility of the CDS market and the implied volatility of the stock market are stronger, especially during the recent credit crunch period. All these results have important implications for the construction of portfolios with credit-sensitive instruments.

TESIS PARA OPTAR AL GRADO DE MAGÍSTER EN FINANZAS / Esta investigación se evalúa si los mercados de CDS (Credit Default Swap) de países emergentes son capaces de anticipar cambios en el rating de la deuda soberana. Se utiliza el rating soberano asignado por parte de las tres grandes agencias clasificadoras de riesgo y los Credit Default Swap soberano a 10 años, para una muestra compuesta por 27 países emergentes. Se utilizaron datos de frecuencia mensual para el periodo comprendido entre septiembre de 2008 y enero de 2018, en el cual se incluyen dos crisis financieras internacionales (crisis subprime y la amenaza de contagio de la crisis de deuda soberana de europa). El modelo econométrico consiste en una estimación en dos fases. En la primera, se estima a través de un modelo de regresión lineal de corte transversal el desalineamiento del spread de CDS de un país con respecto a sus pares de igual clasificación. En la segunda, se utiliza esta innovadora variable para estimar a través de un modelo probit con datos de panel la probabilidad de cambio de rating internalizada por el mercado de CDS. Se analiza de manera independiente los eventos de crédito que mejoran el rating (upgrade) y los que lo rebajan (downgrade). Se comprueba que, incluso utilizando diferentes supuestos para la construcción de las variables, los CDS son un instrumento financiero capaz de entregar información relevante para predecir cambios en el rating soberano. Además, mediante un conjunto de pruebas de robustez, se entrega sustento para dos principales conclusiones. Primero, que el mercado de CDS asignaría una mayor probabilidad de cambio de rating (tanto para downgrade como upgrade) a los países de peor clasificación crediticia y, más aún, a aquel grupo de países con grado especulativo. Segundo, los resultados muestran que a medida que se acerca la fecha del evento, el mercado contaría con mayor información para predecir cambios de rating, lo cual se podría esperar intuitivamente. Esta investigación realiza un aporte a la literatura previa tanto en el modelo implementado como su capacidad predictiva de cambios de rating, la cual se mantiene incluso frente a diferentes especificaciones de las variables explicativa relevantes y cambios en los supuestos utilizados.

This paper seeks to fill a gap in the literature regarding the consequences of banning ‘naked’ Credit Default Swaps (CDS). In particular, I use the European Union’s Ban on ‘naked” Sovereign CDS as an event study to evaluate the impact that banning such derivative products has on the price discovery process in the credit markets. Using both Granger Causality tests and a Vector Error Correction Model, I find that before November 1, 2012, CDS are the clear price leader in the credit markets. However, since the official date the regulation was put into effect, CDS’ price leadership was eroded. Moreover, after the ban, CDS and Bond Yield Spreads are no longer cointegrated in the long run, suggesting that different pricing mechanisms now exist between the two securities

In this letter we discuss the Credit Default Swap (CDS) market for European, Indian and US CDS entities during the financial crisis starting in 2007 using empirical First Significant Digit (FSD) distributions. We find out that on a time aggregated level the European and the US market obey empirical FSD distributions similar to the theoretical ones. Surprising differences are observed in the development of the FSD distributions between the US and the European market. While the FSD distribution of the US derivative market behaves nearly constant during the last financial crisis, we find huge fluctuations in the FSD distributions in the European market. One reason for these differences might be the possibility of a strategic default for US companies due to Chapter 11 and avoided contagion effects. / Series: Research Report Series / Department of Statistics and Mathematics

The objective of this project is to investigate and model the quantitative connection between market prices of credit default swaps and the market perceived probability and timing of default by the underlying borrower. We quantify the credit risk of a borrower in a two-way relationship: calculate the term structure of default probabilities from the market prices of traded CDSs and calculate prices of CDSs from the probability distribution of the time-to-default.