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Pricing default swaps: empirical evidence

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  • Houweling, P.
  • Vorst, A.C.F.

Abstract

In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model with a constant recovery rate outperforms the market practice of directly comparing bonds' credit spreads to default swap premiums. We find that the model works well for investment grade credit default swaps, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is insensitive to the value of the assumed recovery rate

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Bibliographic Info

Paper provided by Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute in its series Econometric Institute Research Papers with number EI 2003-51.

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Date of creation: 07 Aug 2003
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Handle: RePEc:ems:eureir:1083

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Keywords: credit default swaps; credit risk; default risk; recovery rates; reduced form models;

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  1. Jarrow, Robert A. & Turnbull, Stuart M., 2000. "The intersection of market and credit risk," Journal of Banking & Finance, Elsevier, Elsevier, vol. 24(1-2), pages 271-299, January.
  2. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 29(2), pages 449-70, May.
  3. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, American Finance Association, vol. 53(6), pages 2225-2241, December.
  4. Longstaff, Francis A., 2000. "The term structure of very short-term rates: New evidence for the expectations hypothesis," Journal of Financial Economics, Elsevier, Elsevier, vol. 58(3), pages 397-415, December.
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  6. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  7. Sanjiv Ranjan Das & Rangarajan K. Sundaram, 2000. "A Discrete-Time Approach to Arbitrage-Free Pricing of Credit Derivatives," Management Science, INFORMS, INFORMS, vol. 46(1), pages 46-62, January.
  8. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 921-49, July.
  9. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
  10. Darrell Duffie & Lasse Heje Pedersen & Kenneth J. Singleton, 2003. "Modeling Sovereign Yield Spreads: A Case Study of Russian Debt," Journal of Finance, American Finance Association, American Finance Association, vol. 58(1), pages 119-159, 02.
  11. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  12. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 56(3), pages 1095-1115, 06.
  13. Chan, K C, et al, 1992. " An Empirical Comparison of Alternative Models of the Short-Term Interest Rate," Journal of Finance, American Finance Association, American Finance Association, vol. 47(3), pages 1209-27, July.
  14. Gurdip Bakshi & Dilip Madan & Frank Zhang, 2001. "Understanding the role of recovery in default risk models: empirical comparisons and implied recovery rates," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2001-37, Board of Governors of the Federal Reserve System (U.S.).
  15. Philipp J. Schönbucher, 2000. "A Libor Market Model with Default Risk," Bonn Econ Discussion Papers, University of Bonn, Germany bgse15_2001, University of Bonn, Germany.
  16. Duffie, Darrell, 1996. " Special Repo Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 51(2), pages 493-526, June.
  17. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, American Finance Association, vol. 52(4), pages 1287-1321, September.
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