Over time, finance developed to become one of the cornerstones of modern society. The global nature of modern finance, and in particular credit markets, makes the task of distinguishing between good and bad borrowers a difficult one. With the aim of reducing information asymmetry, corporations that wish to borrow from capital markets, resort today to credit rating agencies like Moody’s and Standard & Poor’s, who assess their credit quality and grade it according to a standardized rating scheme. By doing so, credit rating agencies send a clear sign to the market, helping investors to decide who to lend money to and at what rate.
Since 1909, when Moody’s Investors Service published its first rating, the role of rating agencies has become a central one in financial markets. This ascension though, was not achieved in a straight line, as credit rating agencies from time to time found themselves in the center of financial scandals and crises which made regulators rethink the agencies’ roles.
The first event that would shape the business model of credit rating agencies was the default of Penn Central on $82 million of commercial paper in 1970. At this time, agencies provided public ratings of issuers free of charge and relied solely on the publication of reports as means of income. Since reports were easily copied they did not yield enough earnings for agencies to comprehensively scout the market and produce timely ratings.
The market for commercial paper had grown rapidly with no regard for credit quality however, and when Penn Central defaulted, investors started questioning the credit quality of all other companies issuing the same type of debt, demanding more information about market participants and generating a liquidity crisis. This event was the final push towards a “charging the issuers” model as investors were not willing to buy unrated debt anymore. As a consequence, charging the issuers for the ratings was the only sustainable way for agencies to take a significant snapshot of the market.
Contents
1. Introduction
1.1. Research Question
2. Credit and Credit Risk
2.1. Benchmark risk-free rate
3. Fundamentals of Derivatives
3.1. Definition and Terminology
3.2. Credit Derivatives
3.3. Contract Elements
3.4. Market Overview
4. Credit Default Swap
4.1. CDS Description
4.2. Pricing Credit Default Swaps
- 4.2.1. The Rational
4.2.2. Default Probabilities
4.2.3. CDS Premium
4.2.4. Implied Default Probabilities
5. Types of Credit Derivatives
5.1. Asset Swap
5.2. Total Return Swap
5.3. Credit Spread Products
5.4. Credit linked Note
- 5.4.1. Collateralized Debt Obligations
6. Credit Rating Agencies
7. Literature Review
7.1. Corporate Yield Spread: Evidence from the Corporate Bond market
7.2. Corporate Yield Spread: Evidence from the CDS market
7.3. Liquidity in the Credit Default Swap market
7.4. CDSs and Credit Ratings
8. Data & Methodology
8.1. The CDX and Itraxx indices
8.2. The data Set
8.3. Data Analysis
8.4. Constricting the data set
8.5. Methodology
- 8.5.1. Adjusting CDS Spreads
8.5.2. Distribution assumptions and event testing
9. Analysis of the Results
9.1. Results of methodology # 1: CDX and Itraxx indices
9.2. Results of methodology # 1: Sector and Rating Category Indices
9.3. Results of methodology # 2: CDX and Itraxx Indices
9.4. Results of methodology # 2: Sector and Rating Category Indices
10. Discussion
11. Conclusion
12. Acknowledgements
13. References
14. Appendices
Download
Does the Credit Default Swap Market Anticipate or React to Credit Rating Agency Announcements?
