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Rating-based CDS curves

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  • Olga Kolokolova
  • Ming-Tsung Lin
  • Ser-Huang Poon

Abstract

This paper explores the extent to which term structure of individual credit default swap (CDS) spreads can be explained by the firm's rating. Using the Nelson–Siegel model, we construct, for each day, CDS curves from a cross-section of CDS spreads for each rating class. We find that individual CDS deviations from the curve tend to diminish over time and CDS spreads converge towards the fitted curves. The likelihood of convergence increases with the absolute size of the deviation. The convergence is especially stable if CDS spreads are lower relative to the rating-based curve. Trading strategies exploiting the convergence generate an average return of 3.7% (5-day holding period) and 9% (20-day holding period).

Suggested Citation

  • Olga Kolokolova & Ming-Tsung Lin & Ser-Huang Poon, 2019. "Rating-based CDS curves," The European Journal of Finance, Taylor & Francis Journals, vol. 25(7), pages 689-723, May.
    • Handle: RePEc:taf:eurjfi:v:25:y:2019:i:7:p:689-723
    DOI: 10.1080/1351847X.2018.1511441
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    Cited by:

    1. Chan, Ka Kei & Kolokolova, Olga & Lin, Ming-Tsung & Poon, Ser-Huang, 2023. "Price convergence between credit default swap and put option: New evidence," Journal of Empirical Finance, Elsevier, vol. 72(C), pages 188-213.
    2. Shi, Yukun & Stasinakis, Charalampos & Xu, Yaofei & Yan, Cheng, 2022. "Market co-movement between credit default swap curves and option volatility surfaces," International Review of Financial Analysis, Elsevier, vol. 82(C).

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