In the past decade, the credit derivatives market has experienced rapid growth, and among credit derivatives, the credit default swap (CDS) has become the most widely traded instrument for transferring credit risk. According to survey data coordinated by the Bank for International Settlements, by the end of 2005, the total notional amount of outstanding CDS contracts had surpassed $13 trillion. CDS contracts can help isolate credit risk from other factors affecting bond prices such as illiquidity premiums, and thus may provide more accurate pricing and cleaner measurement of credit risk than is available from the underlying debt markets.
Most empirical comparisons of CDS and bond pricing, such as Hull and White (2000), Longstaff, Mithal, and Neiss (2005), Blanco, Brennan, and Marsh (2005), and Zhu (2005) have only considered investment-grade corporate names; these studies generally have concluded that arbitrage forces CDS premiums to be approximately equal to the underlying bond spreads in the absence of market frictions. Blanco, Brennan, and Marsh (2005) also report evidence that corporate CDSs seem to lead corporate bonds in reflecting changes in credit conditions. However, the number of CDS quoted for speculative-grade reference entities, while small until recent years, has since increased rapidly, and it is not obvious that investment-grade empirical regularities are necessarily applicable to riskier credits.
This paper makes three key contributions. First, we analyze the "cheapest to deliver" (CTD) option that is embedded in most CDS contracts, and we show that it can be quite important to determination of hedge ratios and to pricing relationships between bonds and CDS. We present evidence of the empirical importance of the option. Second, we find somewhat different dynamic relationships between CDS and bond prices than in the previous literature. These differences may arise because of the CTD option or because borrowers in our sample are riskier, but the differences in our results are also consistent with the relative importance of public and private information being a key determinant of differences in price dynamics across assets. Third, we examine pricing relationships for sovereign credit risk, with substantial variation in credit spreads over time and across reference entities.
Most prior work on CDS has focused on investment-grade corporate names. Although the number of sovereign reference entities is smaller, cross-sectional relationships are often strong enough so that we obtain statistically significant results, and the sovereign market is large in the sense of the volume of credit risk transfer. Taken together, our arguments and evidence suggest that, particularly as the CDS market extends it reach to more speculative-grade names, market participants may wish to reconsider some features of the standard CDS contract, and may need to revise pricing models, trading strategies, and hedging strategies. There are matters of considerable practical importance to a rapidly growing market.
