CMCDS Data Exploration and Trading Strategies

This paper explores trading strategies to identify possible imbalances that may have been existed in the credit markets, during the period 2001–2006, when pairing CDS and CMCDS on the same name. To this end, a large database of single-name CDS premia is used to produce the corresponding CMCDS prices, derived by implementing common market models. It appears that, in general, it would have been more profitable to sell CDS and to buy CMCDS, since at least 85% of the names analysed had a negative cumulative net trading profit/loss over the 5 years period considered. Contact author: [email protected] 1 Credit derivatives are derivative securities whose payoff is conditioned on the occurrence of a credit event. Credit events typically include bankruptcy, failure to pay, default or restructuring. In practice credit derivatives widely used include total return swaps, spread options, and credit default swaps, but new product emerge every year. Credit default swap (CDS) established itself as one of the most liquid and important instrument, accounting for around a third of the credit market as at the first quarter of 2006 (BBA(2006)). They provide insurance against the risk of a default by a particular company. The purpose credit default swaps is to allow credit risks to be traded and managed in much the same way as market risks. The premium (called the CDS spread) in a CDS spread contract is determined by matching the discounted cash flows of a fixed leg paid by the protection buyer and a loss leg which corresponds to the net payment made by the protection seller to the protection buyer in case of default. As discussed in more detail in Duffie (1999) and Hull and White (2000), the credit default swap spread should be very close to the credit spread of a par yield bond issued by the reference entity over the par yield risk-free rate. This can be shown using a no arbitrage argument. Buying a par yield bond and a CDS on the reference entity an investor eliminates almost all the credit risk associated with default on the bond. This means that, denoting with y the yield on a T -year par yield bond issued by a reference entity, with r the yield on a T -year par yield riskless bond, and with S the T -year CDS spread (i.e. S is the periodical premium paid by the the protection buyer), the relationship S = y− r should hold. In fact, if S is less than y− r, buying a corporate bond and the credit default swap and short selling a riskless bond will result in an arbitrage. If S is greater than y − r, then an arbitrageur will find it profitable to short a corporate bond, sell the credit default swap, and buy a riskless bond. The validity of the theoretical equivalence of CDS spreads and credit bond yield spreads is tested in Blanco et al. (2005). Using a dataset of 33 U.S. and European investment-grade firms it is found that this parity relation holds on average over time for most companies, suggesting that the bond and CDS markets may price credit risk equally. Deviation from parity are found only for three European firms, for which the authors find that CDS prices are substantially higher than credit spreads for long periods of time. These cases are attributed to a combination of both imperfections in the contract specification of CDSs and measurement errors in computing the credit spread. For all the other companies they find only short-lived deviations from parity in the sample. This is because CDS prices lead credit spreads in the price discovery process, meaning that the CDS market leads the bond market in determining the price of credit risk. The relationship between credit default swaps and corporate spreads is investigated also in Longstaff et al. (2005). After developing closed-form expressions for corporate bond prices and credit default swap premium within the familiar Duffie and Singleton (1997, 1999) framework, they use the information in credit default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads. In other words they investigate what proportion of corporate yield spreads is directly attributable to default risk and how much of the spread depend on other factors such as liquidity and taxes. To answer these questions they use the information in credit default swap premia to provide direct measures of the size of the default and nondefault components in corporate yield spreads. Using CDS premia for 5-year contracts and the corresponding corporate bond prices for 68 firms traded during the period March 2001–October 2002, they find that the default component represents the majority of corporate spreads, accounting for more than 50% of the total corporate spread, even for the highest-rated For an overview of credit derivatives see Tavakoli (1998); Schönbucher (2003) 2 Some assumptions and approximations are to be made in this arbitrage argument (see Hull et al., 2004).