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The Number of State Variables for CDS Pricing

Author

Listed:
  • Biao Guo
  • Qian Han
  • Doojin Ryu

Abstract

This study investigates the number of state variables needed for CDS pricing by conducting a principal component analysis using CDS data for the 2006-2009 period. Two state variables, approximated by the first two components, are found sufficient for pricing CDS spreads. The first component corresponds to a market level factor and can explain over 97% of the variation in the data, resulting in a 20.04 bps root mean square error (RMSE). The second component corresponds to a liquidity level factor and can explain an additional 1.7% of the variation, helping to reduce the RMSE to 5.29 bps. A rigorous bootstrap test, together with two robustness tests, on the model performance improvement corroborates our conclusions. The study sheds light on CDS pricing and provides support for the most recent findings that liquidity risk is priced in CDS spreads.

Suggested Citation

  • Biao Guo & Qian Han & Doojin Ryu, 2013. "The Number of State Variables for CDS Pricing," Working Papers 2013-10-14, Wang Yanan Institute for Studies in Economics (WISE), Xiamen University.
    • Handle: RePEc:wyi:wpaper:002044
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    More about this item

    Keywords

    Credit Default Swap; Liquidity; Local Linear Regression; Principal Component;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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