Credit default swap

Summary

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, may expect to receive a payoff if the asset defaults. In the event of default, the buyer of the credit default swap receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan or its market value in cash. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction. The payment received is often substantially less than the

Official source

https://en.wikipedia.org/wiki/Credit_default_swap

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This dissertation consists of three chapters. The first chapter examines whether the availability of credit default swaps (CDS) has consequences for creditor governance. CDSs offer creditors the opportunity to hedge credit risk and may impact their willingness to renegotiate debt agreements after covenant violations and to monitor firms. I show that firms implement more conservative investment and financing policies after covenant violations if CDSs are traded on their debt, consistent with heightened renegotiation frictions. Moreover, firms with traded CDS contracts exhibit significantly worse operating and stock performance after covenant violations. Overall, these findings point to an exacerbation of debt-equity conflicts due to the availability of CDSs. Finally, I analyze the interaction of creditor governance and internal governance, and provide evidence suggesting that the possibility to hedge risk through CDSs also reduces creditors' incentives to monitor firms. The second chapter models the joint effects of debt, macroeconomic conditions, and cash flow cyclicality on risk-shifting behavior and managerial pay-for-performance sensitivity. I show that risk-shifting incentives rise during recessions and that the shareholders can eliminate such adverse incentives by reducing the equity-based compensation in managerial contracts. I also show that this reduction should be larger in highly procyclical firms. Using a sample of U.S. public firms, I provide evidence supportive of the model's prediction. First, I find that equity-based incentives are reduced during recessions. Second, I show that the magnitude of this effect is increasing in a firm's cash flow cyclicality. The third chapter analyzes the impact of the formation of universal banks on corporate investment by looking at the gradual dismantling of the Glass-Steagall Act's separation between commercial and investment banking. Using a matched sample of U.S. firms and their relationship banks, I show that firms curtail investment after positive shocks to the underwriting capacity of their main bank. This result is driven by unrated firms and is strongest in the first two years after a shock. Moreover, I obtain similar results for borrowing firms' net debt issuance activity. As an exogenous shock to the formation of universal banks in the U.S., I also use the 1997 loosening of restrictions on commercial banks' securities activities. My findings suggest that universal banks may pay more attention to large and transparent firms that provide more underwriting opportunities while exacerbating financial constraints of opaque firms.

EPFL2015

Essays on the Market Structure and Pricing of Credit Derivatives

Jan Benjamin Junge

This thesis analyzes the interrelation between market structure and price formation in credit derivatives markets. Traditionally, credit derivatives are traded in relatively opaque over-the-counter markets in which trading is segmented and subject to many imperfections from which illiquidity may arise. Recent regulatory reforms have brought transparency to some credit derivatives markets without affecting their segmented structures. The first chapter, which is joint work with Anders B. Trolle, analyzes whether liquidity risk is priced in the cross section of returns on credit default swaps (CDSs). The analysis is based on a factor pricing model and a tradable liquidity factor that is constructed from returns on index arbitrage strategies. The underlying presumption is that violations of simple no-arbitrage relations between different CDS contracts reflect constraints on the risk-bearing capacity of CDS market intermediaries and, in broad terms, CDS market illiquidity. The analysis reveals priced liquidity risk in that credit protection sellers earn higher expected excess returns on CDS contracts with higher liquidity exposures. The liquidity risk premium is significant and accounts for 24% of CDS spreads, on average. CDS risk premia correlate negatively with proxies for the risk-bearing capacity of CDS market intermediaries, which is consistent with intermediary frictions affecting the pricing of CDSs. The second chapter, which is joint work with Pierre Collin-Dufresne and Anders B. Trolle, analyzes transaction costs in the dealer-to-customer (D2C) and dealer-to-dealer (D2D) segments of the post-Dodd-Frank index CDS market. Dodd-Frank regulations that made all-to-all trading possible had the potential to break up the market's segmented structure but failed to do so. This led to a controversy with some market participants arguing that the segmented structure is optimal and other market participants arguing that dealers maintain the segmented structure in order to limit competition by alternative liquidity providers. The analysis reveals that D2C trades indeed have larger transaction costs than D2D trades but that the differences in transaction costs reflect differences in price impacts rather than differences in profits from liquidity provision. D2C trades are even competitive relative to executable bids and offers in the D2D segment, suggesting that the market structure delivers favorable prices for customers who value immediacy. The third chapter documents a decline of transaction costs and profits from liquidity provision in the index CDS market over a two-and-a-half-year period during which Dodd-Frank regulations were implemented. Transaction costs and profits from liquidity provision declined around the introduction of so-called swap execution facilities (SEFs); i.e., regulated trading platforms that offer pre-trade transparent methods of trade execution. Trades that are executed on SEFs have lower transaction costs and are less profitable from a liquidity provider's perspective in comparison to bilaterally negotiated trades, which is consistent with better comparison shopping and stronger price competition on SEFs. Dodd-Frank regulations mandating on-SEF trade execution that were implemented after the introduction of SEFs did not affect transaction costs and profits from liquidity provision, suggesting that there is no incremental effect associated with mandatory pre-trade transparency.

EPFL2016

Polynomial models in finance

Damien Edouard Ackerer

This thesis presents new flexible dynamic stochastic models for the evolution of market prices and new methods for the valuation of derivatives. These models and methods build on the recently characterized class of polynomial jump-diffusion processes for which the conditional moments are analytic. The first half of this thesis is concerned with modelling the fluctuations in the volatility of stock prices, and with the valuation of options on the stock. A new stochastic volatility model for which the squared volatility follows a Jacobi process is presented in the first chapter. The stock price volatility is allowed to continuously fluctuate between a lower and an upper bound, and option prices have closed-form series representations when their payoff functions depend on the stock price at finitely many dates. Truncating these series at some finite order entails accurate option price approximations. This method builds on the series expansion of the ratio between the log price density and an auxiliary density, with respect to an orthonormal basis of polynomials in a weighted Lebesgue space. When the payoff functions can be similarly expanded, the method is particularly efficient computationally. In the second chapter, more flexible choices of weighted spaces are studied in order to obtain new series representations for option prices with faster convergence rates. The option price approximation method can then be applied to various stochastic volatility models. The second half of this thesis is concerned with modelling the default times of firms, and with the pricing of credit risk securities. A new class of credit risk models in which the firm default probability is linear in the factors is presented in the third chapter. The prices of defaultable bonds and credit default swaps have explicit linear-rational expressions in the factors. A polynomial model with compact support and bounded default intensities is developed. This property is exploited to approximate credit derivatives prices by interpolating their payoff functions with polynomials. In the fourth chapter, the joint term structure of default probabilities is flexibly modelled using factor copulas. A generic static framework is developed in which the prices of high dimensional and complex credit securities can be efficiently and exactly computed. Dynamic credit risk models with significant default dependence can in turn be constructed by combining polynomial factor copulas and linear credit risk models.

EPFL2017