Once unregulated and unruly, credit default swaps are now part of the fabric of capital markets. A recent study by Refinitiv tracks how credit default swap (CDS) rates react to changes in probability of default (PD), and how the company’s StarMine Structural Credit Risk model can predict the direction of CDS rate changes.
- There is a relationship between probability of default changes and credit default swap rate changes.
- A larger probability of default causes a larger future increase in the CDS rate.
- Refinitiv StarMine credit risk models can predict the direction of CDS rate changes.
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Credit default swaps have a chequered history. Introduced to capital markets by JP Morgan in 1994 as unregulated credit derivative contracts to insure the firm against the risk of default on the loans it held in its books, their use increased in the early 2000s, only to be cut down when they were identified as an underlying cause of the 2008 financial crisis.
They have since been regulated by the Dodd-Frank Act in the U.S. and the Markets in Financial Instruments Directive (MiFID) in the EU.
What is a CDS?
Essentially, a CDS is a contract that provides insurance against a credit event at a company, such as default, bankruptcy, or debt restructuring. The buyer of protection agrees to pay periodic insurance premiums to the protection seller, until the expiration of the contract or a contractually defined time, whichever occurs earliest.
If the credit event occurs, the buyer of protection obtains the right to sell bonds issued by the insured company to the insurance seller. The buyer also pays the accrued portion of the payment since the last payment date. The annualised payment rate is the CDS rate.
Refinitiv study reveals nature of CDS and PD link
Previous academic work has shown that the PD and CDS rate are related, and that a change in PD should trigger a simultaneous change in the CDS rate.
The Refinitiv study found that CDS rates do change as a result of PD changes, but with some delay, suggesting an opportunity for the construction of trading strategies.
An initial review of agency ratings found the rating changes were not updated frequently enough to demonstrate the expected relationship between an agency rating and CDS.
StarMine credit risk models
The study moved on to use a more frequently updated PD, in this case provided by Refinitiv StarMine credit risk models.
Among these risk models, the StarMine Credit Risk model, which evaluates the equity market’s view of the probability that a company will go bankrupt or default on its debt obligations over the next one-year period, showed the greatest response of CDS rates to changes in trailing PD changes.
Direction of CDS rate changes
Overall, the study shows the Refinitiv StarMine Credit Risk model predicting the direction of CDS rate changes in five different scenarios – download the report to dig into the details of all five scenarios.
The study may provide a springboard for development of additional StarMine models that could further explore the relationship between PD changes and CDS rate changes in trading strategies.