A remarkable innovation in the credit risk market in the past ten years has been the development of the credit derivatives market. Credit derivatives are over-the-counter financial contracts whose payoffs are linked to changes in the credit quality of an underlying asset (known as the reference entity).
Since the introduction of these credit protection instruments, the market has grown dramatically and become an important tool for financial institutions to shed or take on credit risk. According to the biennial survey by the British Bankers’ Association, the credit derivatives market grew from a USD 40 billion outstanding notional value in 1996 to an estimated USD 1.2 trillion at the end of 2001, and is expected to zoom up to USD 4.8 trillion by the end of 2004.
Among various credit derivative instruments the credit default swap (CDS) is the most widely traded, capturing nearly half (45%) of the market share. A CDS provides insurance against the risk of default by a reference entity. The protection seller is obliged to buy the reference bond at its par value when a credit event (bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation / moratorium, or restructuring) occurs. In return, the protection buyer makes periodic payments to the seller until the maturity date of the CDS contract or when a credit event occurs, whichever comes first. This periodic payment, which is usually expressed as a percentage (in basis points) of its notional value, is called the CDS spread (or the CDS premium). Intuitively, this CDS spread provides an alternative market price of the credit risk of the reference entity in addition to its corporate bond yield from the cash market.
This paper tries to address two important questions that have significant implications for risk managers and financial regulators. First, is the credit risk priced equally between the derivatives market and the traditional cash market (ie the accuracy of credit risk pricing)? Although widespread trading of credit derivative instruments could potentially prompt active arbitrage of credit risk across markets, there are risks that these instruments are priced incorrectly (for example, because of low financial transparency and the existence of asymmetric information between protection buyers and sellers).
Given the fact that the insurance sector and small regional banks have been net sellers of credit protection to large banks (see Fitch (2003)), the answer to this question could have important implications for credit risk transfer within the banking industry and across financial sectors. Second, which market moves more quickly in reflecting changes in credit conditions (ie the efficiency of price discovery)? If the two markets exhibit different responses, traders could potentially take the opportunity to gain from the price differentials.
