FINANCIAL ANALYSIS

The Relationship between Credit Default Swap Spreads, Bond Spreads and Credit Rating Announcements

Table of Contents

Table of Contents2

Abstract3

Chapter 14

Introduction4

Objective of the Study6

Structure of the Study6

Chapter 212

Literature Review12

Credit-default swaps22

Credit Risk26

Credit Deterioration Risk28

Chapter 330

Methodology30

The CDS Data Set30

CDS Spreads and Bond Spreads32

Alternative Risk-Free Rates34

Test of Equation (2)36

Chapter 439

Findings39

The Benchmark Risk-Free Rate39

CDS Spreads and Rating Changes41

Spread Changes Conditional on Rating Events44

Estimating the Probability of Rating Events47

Chapter 549

Conclusion49

List of Tables51

References55

Abstract

A company's credit default swap spread is the cost per annum for protection against a default by the company. In this paper we analyze data on credit default swap spreads collected by a credit derivatives broker. We first examine the relationship between credit default spreads and bond spreads and reach conclusions on the benchmark risk-free rate used by participants in the credit derivatives market. We then carry out a series of tests to explore the extent to which credit rating announcements by Moody's are anticipated by participants in the credit default swap market.

Chapter 1

Introduction

Credit derivatives are an exciting innovation in financial markets. They have the potential to allow companies to trade and manage credit risks in much the same way as market risks. The most popular credit derivative is a credit default swap (CDS). This contract provides insurance against a default by a particular company or sovereign entity. The company is known as the reference entity and a default by the company is known as a credit event. The buyer of the insurance makes periodic payments to the seller and in return obtains the right to sell a bond issued by the reference entity for its face value if a credit event occurs.

The rate of payments made per year by the buyer is known as the CDS spread. Suppose that the CDS spread for a five-year contract on Ford Motor Credit with a principal of$10 million is 300 basis points. This means that the buyer pays $300,000 per year and obtains the right to sell bonds with a face value of $1 0 million issued by Ford for the face value in the event of a default by Ford. The credit default swap market has grown rapidly since the International Swaps and Derivatives Association produced its first version of a standardized contract in 1998.

Credit ratings for sovereign and corporate bond issues have been produced in the United States by rating agencies such as Moody's and Standard and Poor's (S&P) for many years. In the case of Moody's the best rating is Aaa. Bonds with this rating are considered to have almost no chance of defaulting in the near future. The next best rating is Aa. After that come A, Baa, Ba, Band Caa. The S&P ratings corresponding to Moody's Aaa, Aa, A, Baa, Ba, B, and Caa are AAA, AA, A, BBB, BB, B, and CCC respectively.

To create finer rating categories Moody's divides its Aa category into Aal, Aa2, and Aa3; it divides A into AI, A2, and A3; and so on. Similarly S&P divides its AA category into AA+, AA, and AA-; it divides its ...