With the onset of the financial crisis in 2007, Credit default swaps (CDS) made the transition from being an esoteric financial instrument to appearing on the front page of mainstream newspapers. This increase in public awareness resulted from their implication in a series of high profile company failures, most notably that of the American Insurance Group, AIG, which posted a record loss of US$61.7bn in the fourth quarter of 2008. In its simplest form, a CDS is a privately negotiated contract that insures the holder against any losses in the event that the issuer of a bond defaults on their payment obligations. The holder makes a periodic payment in return for this service, called the spread. The spread is conceptually similar to the premium charged by an insurance company and compensates the issuer for the risk they incur in providing the guarantee (the losses incurred during the current financial crisis tend to suggest that CDS were significantly underpriced relative to their true risk).
Academia has a long standing interest in the burgeoning CDS market and a substantial body of work has developed which focuses on credit sensitive instruments. This literature is broadly categorized based on two theoretical approaches to pricing corporate bonds and credit spreads. Reduced-form models, developed by Litterman and Iben (1991), Jarrow and Turnbull (1995) and Jarrow, Landow and Turnbull (1997), use market data to recover the parameters needed to value credit-sensitive claims. Empirical applications of reduced-form models include Duffee (1999) and Duffie, Pedersen, and Singleton (2003).
The second approach, developed by Black and Scholes (1973) and Merton (1974), uses structural models to connect the price of credit-sensitive instruments directly to the economic determinants of financial distress and loss given default. Structural models imply that the main determinants of the likelihood and severity of default are financial leverage, volatility, and the risk-free term structure. Collin Dufresne, Goldstein, and Martin (2001) use the structural approach to identify the theoretical determinants of corporate bond credit spreads.
These variables are then used as explanatory variables in regressions for changes in corporate credit spreads, rather than inputs to a particular structural model. Collin-Dufresne et al. (2001) find that the explanatory power of the theoretical variables is modest, and that a significant part of the residuals is driven by a common systematic factor that is not captured by the theoretical variables. Campbell and Taksler (2003) extend this analysis using regressions for levels of the corporate bond spread, rather than changes in corporate credit spreads. They show that firm specific equity volatility is an important determinant of credit spreads, and that the economic effects of volatility are large. Cremers, Driessen, Maenhout, and Weinbaum (2004) confirm and extend this analysis by showing that option-based volatility contains increased explanatory power that is different from historical volatility.
This previous literature focuses on corporate bond spreads, i.e. the difference between the corporate bond yield and the risk free rate. More recent studies however, (see Benkert, 2004, Greatrex, 2009, Ericsson, Jacobs, and Oviedo, 2009, and Zhang, Zhou, and Zhu, 2009) focus on the relationship between CDS spreads and key variables suggested by economic theory. Thus, while the main focus of these more recent papers remains on credit risk, an important distinction is the use of CDS spreads rather than corporate bond spreads as the variable of interest.
