Ebook Restructuring Risk in Credit Default Swaps: An Empirical Analysis
Since their emergence in the late 1990s, credit default swap (CDS) markets have grown exponentially, to an estimated outstanding notional value of 17.1 trillion dollars in 2005. This phenomenal growth is due to the fact that CDS provide an essential tool for hedging credit risk in financial markets. CDS are financial instruments that provide insurance against a credit event destroying value in an entity’s (usually a corporation’s) debt.
The insurer of the credit event is paid a premium (usually quarterly) over a fixed time period to provide the insurance. And, the insured gets reimbursed for any losses in the value of the entity’s debt, if a credit event occurs over the contract’s life. Various different types of CDS trade, differentiated with respect to: the maturity of the contract, whether the reimbursement procedure requires physical delivery of the debt issue or not, and the definition of a credit event. This paper concentrates on the last provision.
In the definition of a credit event, the crucial distinction is between default and financial restructuring. Default occurs when the borrower violates the debt contract’s covenants (e.g. a failure to pay required interest or principal on time), and financial restructuring occurs when the financial liabilities of the borrowing entity are changed. Default clearly destroys the value of an entity’s debt. But, a financial restructuring could also destroy existing debt value, even if the entity does not default. For example, the restructuring could change the debt contract’s subordination, reducing its priority in the event of default. An open question is the importance of this “restructuring event” in the market pricing of CDS. This paper provides both an empirical and theoretical investigation of this issue.
First, we present an empirical investigation of the restructuring credit risk premium for the U.S. corporate bond market during 1999-2005. Comparing default swap contracts that include restructuring and those that do not, we find that the average premium for restructuring risk represents 6% to 8% of the swap rate without restructuring. This is an economically significant risk premium. Everything else constant, we find restructuring premia to be highest in the Telephone, Service & Leisure and Railroad sectors, and lowest in the Oil and Gas industry and for Gas utilities. And, when default swap rates without a restructuring clause increase, the increase in the restructuring premium is higher for high-yield CDS and lower for investment-grade firms.
Next, we fit a regression model to identify the determinants of CDS rates after controlling for the restructuring clause, the time to maturity of the contract, and changing International Swaps and Derivatives Association (ISDA) regulations. Key explanatory variables include the distance to default (a proxy for default risk), the level and slope of the risk-free forward rate curve, a stock-market volatility index, Moody’s Baa corporate bond yield, and the spread between Moody’s Aaa yield and the 20-year Treasury yield. The model fits the data well, with an R of almost 60% for a linear model, and over 71% when using a logarithmic model.
Last, we provide a reduced-form arbitrage-free model for CDS pricing that explicitly takes into account the restructuring clause. We incorporate both default and restructuring as separate events, where restructuring (if it occurs and default has not) causes a jump in the default intensity. The jump size can be positive or negative, and possibly random. A negative jump is interpreted as a successful restructuring, while a positive jump is interpreted as an unsuccessful restructuring. Our model formulation extends the primary-secondary framework of Jarrow and Yu (2001), where a primary firm’s default causes a jump in a secondary firm’s default intensity.
The remainder of this paper is organized as follows. Section 2 gives a brief description of the CDS restructuring rules. Section 3 describes the CDS data used in this study. Section 4 provides a panel data regression to estimate a model for restructuring risk premia. Section 5 develops a reduced-form model for pricing CDS under different restructuring clauses, and it applies this model as a case study for Ford Motor Company. Finally, Section 6 concludes.
Download
PDF Ebook Restructuring Risk in Credit Default Swaps: An Empirical Analysis
Posted in :
