Transcript CDS Spread Determinants

Determinants of Credit
Default Swap Spread:
Evidence from the Japanese
Credit Derivative Market
Agenda
Introduction
 Data
 Regression Analysis
 Robustness Check
 Conclusion

Introduction CDS Market Overview

In the left-hand panel of this Graph
,Remolona and Shim (2008) shows that
Asia-Pacific names comprise almost a
quarter of all those traded around the world

In right-hand panel, for a breakdown by
economy within the region, this list shows a
total of 921 names.

Japan has the greatest number of names in
Asia-Pacific.

we consider Japan play an important role in
the Asia-Pacific area.

Therefore, it is of interest to study credit
spread determinants on Japan dataset,

The current study fills the gap in the
literature by examining CDS spread in
Japan market.
Introduction
Level
Credit Spread of
Economic Model
Data
Difference
Regression Analysis
Robustness Check
Conclusion
Credit Spread Dynamics
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Structured Model

Black and Scholes(1973)

Merton(1974)
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Collin-Dufresne,
Goldstein, and
Martin(2001)

Structured Model
Reduce-form
Model
•Default Intensity
Default Intensity
process
Firm value process
Ericsson, Jacobs, and
Oviedo(2005)
•Leverage level
•Volatility
•Default Prob.
•Recovery Rate
•Risk-free Rate
In this paper, we apply the structure model to the empirical
examination of the Japanese CDS market, because it
obviously describes the default mechanism and enables us to
analyze the relationship between credit spread and financial
and macroeconomic variables.
Credit Spread
On the other hand, a reduced-form model
assumes that a default process is
unobservable and a latent factor known as
default intensity determines the probability
of default.
CDS Spread
Brief summary of Credit Spread Drivers
Leverage level
Volatility
Risk-free Rate
Macroeconomic
Factors
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Credit Spread
•First, The higher leverage of a firm, the higher probability of
default.
•Second, increasing volatility will increase the default
probability.
•Third, the risk-free rate determines the risk-adjusted drift of
firm value and thus an increase in the risk-free rate tends to
decrease risk-adjusted default probabilities.
•There is a negative relation between risk-free rate and credit
spread.
Data
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Requirement of Dataset:
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cds spread from Markit Group
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180-day historical volatility ,leverage ratio from PACAP database.

Risk-Free Rate: Weekly data on 2-year Japan government bond
yields are collected from Datastream database.
Observed firm:
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At least 252 observations of CDS Spread
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106 Japanese firms from Markit Group database
Data Period : January 2001 to December 2004
Regression Analysis
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Dependent Variable

CDS Spread Level
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CDS Spread difference in a period
Explanatory Variables
We run univariate and multivariate regressions for the CDS
spread and CDS Spread difference on explanatory variables
based on the theory of the main determinants of credit spread.
We further separate the whole sample into sub-samples by
various criteria. For example by credit rating, different sample
period, and financial and non-financial industries.
In general, our findings remain robust after
controlling these various criteria.
Book Value of Debt
Market Value of Equity  Book Value of Debt

Leverage:

Historical Volatility: Sampling from 180 daily return of stock price in a shifting
window
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Risk-free Rate: weekly data on 2-year Japan Government Bond Yield
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Square of Risk-free Rate: To Capture potential nonlinear effect for Risk-free
Rate
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Slope of yield Curve :Difference between 2-year and 10-year Japan
Government Bond Yield which convey information on economic condition

Market Return: Proxy for the overall business climate
Result
• Table 1 Cross-sectional summary statistics
• Table 2 Empirical results for the whole sample
• Table 3 Results partitioned by credit rating
• Table 4 Results partitioned by different sub-sample
periods (whole 2001-2004; separate into 2001-2002 &2003-2004 )
• Table 5 Results partitioned by financial and nonfinancial industry
From Table 3 to 5 , we reports Results partitioned by various criteria.
Table 1
Panel A indicates that there are firms with very high levels of CDS spreads.
Panel B shows that financial leverage, firm specific volatility, and the risk-free rate, are more related to the CDS spread.
Table 2
From table 2 to table 6, we have the same table format, In Panel A is for level data and Panel B is for difference data.
From table 2 to table 6, Regressions for level data has higher explanatory power over regressions based on difference data.
First, we find that the coefficients on leverage are significant and positive. Second, the coefficients on historical volatility are also positively
significant. Third, the results on the risk-free rate has a significant negative relation between CDS spread level and risk-free rate.
Table 3
For lower credit rating firms, leverage ,historical volatility and risk-free rate are more sensitive to
CDS spread than higher credit rating firms..
Table 4
We find that, in general, the results for the sub-sample periods are very similar to each other and to the whole sample period results.
In general, our results in Table 4 suggest that the theoretical explanatory variables remain robust to explain the CDS spread for different
time periods in Japan.
Table 5
The theoretical variables, such as leverage; historical volatility, and risk-free rate show similar results as the whole
sample.
However, the results for financial industry show different pattern, compared to non-financial industry, which may be due
to unique characteristics of financial firms. In general, our findings remain robust after controlling financial and nonfinancial industry firms.
Robustness Check
 A robustness check using an alternative
approach.
Following Collin-Dufresne, Goldstein, and
Martin (2001) and Ericsson, Jacobs, and Oviedo
(2005), we estimate the coefficients by first
running the time-series regressions for each firm
Calculate the cross-sectional mean of the
estimated coefficients.
Table 6
The results are similar to those in the previous section.
Conclusion
This study investigates the determinants of CDS spread for the
Japanese market and contributes the literature.
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Effects of level in leverage and implied volatility on CDS
spread are positively significant.
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A negative relation between risk-free rate and CDS
spread.
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Theoretical determinants perform well in explaining crosssectional variation in the level of CDS spread.
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Limited explanatory power on the difference 0f CDS
spread.
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Findings are consistent with the theory with statistical
significance.