Credit risk, valuation and fundamental analysis

This article establishes an original methodology to forecast macroeconomy based on the term structure of credit spreads. It combines the traditional Svensson model with genetic algorithms to obtain the interest rate term structures of government bonds and corporate bonds and calculates credit spreads as their differences. And this article defines three factors of the term structure of credit spreads: level, slope and curvature. Based on these three factors and several macroeconomic variables, VAR models are developed and tested to forecast macroeconomic variables. The empirical results confirm that VAR models can predict the changes of China's macroeconomy well, which indicates that the term structure of credit spreads contains information of future changes of macroeconomic variables. We believe this result has significant implications for macroeconomy policy-makers.

This paper develops a two-dimensional structural framework for valuing credit default swaps and corporate bonds in the presence of default contagion. Modelling the values of related firms as correlated geometric Brownian motions with exponential default barriers, analytical formulae are obtained for both credit default swap spreads and corporate bond yields. The credit dependence structure is influenced by both a longer-term correlation structure as well as by the possibility of default contagion. In this way, the model is able to generate a diverse range of shapes for the term structure of credit spreads using realistic values for input parameters.

The Term Structure of Credit Spreads in Project Finance

Comparing asset swap spreads across bonds is a widely used tool for measuring relative value. This approach leads portfolio managers to increase their risk exposure in ways that are not transparent. Credit default swaps are utilized to demonstrate that viewing wide asset swaps as an indicator of relative value is a mirage. The paper documents the empirical regularities in the term structure of credit spreads and spread volatilities that make this result possible. In addition, we present empirical evidence of the imprint made on corporate bond returns by the widespread use of the asset swaps data.

This article proposes a new dynamically consistent framework for joint valuation of equity derivatives and credit products, in which uncertainty of the economy is represented by Lévy processes. In the framework, the pre-default stock price of a given firm is presented by an extended exponential Lévy model, while the default arrival rate is presented by the Cox proportional hazard model with stochastic covariates driven by Lévy processes. Under the model, we find the solution of the pricing generator for evaluating equity and credit derivatives, and we derive the pricing formulas of equity call options and credit default swaps by utilizing the pricing generator. In the numerical examples, setting the variance gamma (VG) process and the Brownian motion as driving factors of the model, we compute term structure of credit default swaps and equity implied volatility skews. We also examine the impact of the convexity adjustment on term structure of credit spreads both analytically and numerically.

On Recovery and Intensity's Correlation - A New Class of Credit Risk Models

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank. CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price. Regulation is found to induce the risk-neutral bank to behave in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases. CDS trading is found to interact with the former effect when regulation accepts CDS as an instrument to mitigate credit risk. Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased. However, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased. This promotes the intention of the Basel II (and III) regulations to “strengthen the soundness and stability of banks”.

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank . CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price . Regulation is found to induce the risk-neutral bank to behav e in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases . CDS trading is found to interact with the former ef fect when regulation accepts CDS as an instrument to mitigate credit risk . Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased . Howev er, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased . This promotes the intention of the Basel II (and III) r egulations to “strengthen the soundness and stability of banks” . * Paper presented at the 2012 conferences of the European Financial Management Association (EFMA) in Barcelona and the Verein fur Socialpolitik in Gottingen, at the 2011 conference of the German Economic Association of Business Administration (GEABA) in Zurich, at the Financial Risks International Forum 2012 in Paris, at the 2011 workshop of the Research Task Force of the Basel Committee on Banking Supervision in Istanbul, and at the Bundesbank Research Seminar in Frankfurt . We w ould like to thank conference, workshop and seminar participants and in particular Ulrich Krueger, Peter Raupach, Thomas Gehrig, Bent Vale and Nikolaos Papanikolaou for valuable comments and suggestions . The views expr essed in this paper represent the authors’ personal opinions and do not neces

Do Credit Spreads Reflect Stationary Leverage Ratios? Reconciling Structural and Reduced-Form Frameworks

SYNOPTIC ABSTRACTWe expand the Merton's structural credit risk model into a model that includes an underlying asset process with a non-Gaussian and serially correlated stochastic nature. Using a standard Edgeworth expansion, we arrive at closed-form analytic expressions for the probability of default, the distance to default, and the term structure of credit spread, allowing us to evaluate more accurately the credit risk of incorporating nonnormal asset returns. Moody's KMV (Kealhofer, McQuown, and Vasicek) analogous procedures are proposed for the estimation of the model parameters. Empirical applications for credit-risk evaluation are illustrated, which reveal the significant effects on credit risk due to the non-Gaussianity of the underlying firm's asset process.

In this study, we utilize a comprehensive dataset of US-traded credit default swaps (CDS) to assess the impact of environmental, social, and governance (ESG) adoption on firm credit risk. Our study examines corporate bonds with key maturities from 0.5 to 30 years, covering data from 2007 to 2022. We apply fixed effects regression to analyse the impact of ESG scores on CDS spreads. The results are validated through a battery of robustness checks primarily the 2SLS method. The study finds that ESG scores, including the individual pillars, play a significant role in mitigating credit risk. The intriguing aspect of the finding is the decline in risk mitigation as the term-to-maturity increases. Further, the social pillar causes the highest sensitivity to credit risk, followed by the environmental and governance pillars. The effect of ESG adoption is slightly greater for subordinated bonds compared to senior tranches, however, the effects diverge for individual pillars. The study offers practical insights as understanding the relationship between sustainable practices and CDS term structure helps refine investment strategies and specifically pricing of credit risk.

Accounting Transparency and the Term Structure of Credit Spreads

Credit risk pricing is perhaps an understudied topic in comparisons to its profound impact on the world’s financial markets and economies. This study uses established price discovery techniques to develop a method of price discovery for credit risk in three financial markets: equity, debt, and credit derivative. This chapter is motivated by the development of credit-related instruments and signals of stock price movements of South-Eastern European countries—Bulgaria, Croatia, Greece, Hungary, Romania, Slovenia, Slovakia, and Turkey—during the recent financial crisis. In this study, the authors evaluate the dynamics of fiscal risk or country risk measured by sovereign Credit Default Swap (CDS), liquidity risk measured bond markets, and stock markets for the monthly based September 2008 – February 2011 period. The study examines monthly data observing 38 months and 8 countries. A panel vector autoregression model is proposed for changes in Long-Term Interest Rate (LTIR), changes in CDS spreads (CDS), and changes in stock index. In conclusion, CDS markets and stock markets are more significant than bond markets in explaining the post-crisis relationship among developing South-Eastern European countries. The analysis displays that long-term monetary policy did not affect CDS premium and stock index level. A strong relationship is found between the CDS spread and stock market. During financial crisis and after the crisis, the correlations among CDS, stock, and bond markets are collapsed by panicked investors’ rapid movement and wild speculators. This risk perception can explain the difference between the finance theory and practices in the market.

Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk

Credit default swaps (CDS) are derivative contracts that are widely used as tools for credit risk management. However, in recent years, concerns have been raised about whether CDS trading itself affects the credit risk of the reference entities. We use a unique, comprehensive sample covering CDS trading of 901 North American corporate issuers, between June 1997 and April 2009, to address this question. We find that the probability of both a credit rating downgrade and bankruptcy increase, with large economic magnitudes, after the inception of CDS trading. This finding is robust to controlling for the endogeneity of CDS trading. Beyond the CDS introduction effect, we show that firms with relatively larger amounts of CDS contracts outstanding, and those with relatively more no restructuring contracts than other types of CDS contracts covering restructuring, are more adversely affected by CDS trading. Moreover, the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure for the resolution of financial distress.