scholarly journals Estimating Loss Given Default from CDS under Weak Identification*

2020 ◽  
Author(s):  
Lily Y Liu
Keyword(s):  
Time Series ◽  
Term Structure ◽  
Risk Premia ◽  
Reduced Form ◽  
Probability Of Default ◽  
Weak Identification ◽  
Loss Given Default ◽  
Default Intensity ◽  
Credit Default ◽  
Identification Strategy

Abstract Existing reduced-form default intensity models that jointly estimate probability of default (PD) and loss given default (LGD) from credit default swaps (CDSs) produce dissimilar results, and there is little guidance on which time series specification to choose. This article develops a model of CDS term structure without parametric time series restrictions for PD and uses weak-identification robust methods to investigate whether separate identification of PD and LGD is still possible. Consistent with intuition about the identification strategy, the model is not globally identified. However, in my empirical application, LGD is precisely estimated for half of the firm-months under study, with resulting values much lower than conventional values. This implies that the risk-neutral PD and the risk premia on PD are underestimated when LGD is set to conventional values.

MULTI-CURRENCY CREDIT DEFAULT SWAPS

2019 ◽  
Vol 22 (04) ◽  
pp. 1950018
Author(s):  
DAMIANO BRIGO ◽  
NICOLA PEDE ◽  
ANDREA PETRELLI
Keyword(s):  
Foreign Currency ◽  
Debt Crisis ◽  
Credit Default Swaps ◽  
Reduced Form ◽  
Default Time ◽  
Developed Markets ◽  
Default Intensity ◽  
Diffusion Dynamics ◽  
Credit Default ◽  
The Republic

Credit default swaps (CDS) on a reference entity may be traded in multiple currencies, in that, protection upon default may be offered either in the currency where the entity resides, or in a more liquid and global foreign currency. In this situation, currency fluctuations clearly introduce a source of risk on CDS spreads. For emerging markets, but in some cases even in well-developed markets, the risk of dramatic foreign exchange (FX)-rate devaluation in conjunction with default events is relevant. We address this issue by proposing and implementing a model that considers the risk of foreign currency devaluation that is synchronous with default of the reference entity. As a fundamental case, we consider the sovereign CDSs on Italy, quoted both in EUR and USD. Preliminary results indicate that perceived risks of devaluation can induce a significant basis across domestic and foreign CDS quotes. For the Republic of Italy, a USD CDS spread quote of 440 bps can translate into an EUR quote of 350[Formula: see text]bps in the middle of the Euro-debt crisis in the first week of May 2012. More recently, from June 2013, the basis spreads between the EUR quotes and the USD quotes are in the range around 40[Formula: see text]bps. We explain in detail the sources for such discrepancies. Our modeling approach is based on the reduced form framework for credit risk, where the default time is modeled in a Cox process setting with explicit diffusion dynamics for default intensity/hazard rate and exponential jump to default. For the FX part, we include an explicit default-driven jump in the FX dynamics. As our results show, such a mechanism provides a further and more effective way to model credit/FX dependency than the instantaneous correlation that can be imposed among the driving Brownian motions of default intensity and FX rates, as it is not possible to explain the observed basis spreads during the Euro-debt crisis by using the latter mechanism alone.

The Term Structure of Expected Recovery Rates

2018 ◽  
Vol 53 (6) ◽  
pp. 2619-2661 ◽  
Author(s):  
Hitesh Doshi ◽  
Redouane Elkamhi ◽  
Chayawat Ornthanalai
Keyword(s):  
Term Structure ◽  
Empirical Work ◽  
Reduced Form ◽  
Short Term ◽  
Term Survival ◽  
Recovery Rates ◽  
No Arbitrage ◽  
Widespread Agreement ◽  
Credit Default ◽  
Short Term Survival

There is widespread agreement that corporate debts’ recovery rates are time varying, but empirical work in this area is limited. We show that the joint information from the term structure of senior and subordinate credit default swaps can identify the level and the dynamics of recovery rates. We estimate a reduced-form no-arbitrage model on 46 firms across different industries. We find that the term structure of expected recovery rates is, on average, downward sloping. However, an inversion occurs during the 2008 crisis, suggesting the market expects higher recoveries conditional on short-term survival. The inversion is more pronounced for firms in distressed industries.

Real Economic Shocks and Sovereign Credit Risk

2016 ◽  
Vol 51 (2) ◽  
pp. 541-587 ◽  
Author(s):  
Patrick Augustin ◽  
Roméo Tédongap
Keyword(s):  
Term Structure ◽  
Credit Default Swap ◽  
Reduced Form ◽  
Macroeconomic Risk ◽  
Consumption Volatility ◽  
Sovereign Spreads ◽  
Macroeconomic Uncertainty ◽  
Credit Default ◽  
Sovereign Credit Risk ◽  
Country Specific

AbstractWe provide new empirical evidence that U.S. expected growth and consumption volatility are closely related to the strong comovement in sovereign spreads. We rationalize these findings in an equilibrium model with recursive utility for credit default swap (CDS) spreads. The framework links a reduced-form default process with country-specific sensitivity to expected growth and macroeconomic uncertainty. Exploiting the high-frequency information in the CDS term structure across 38 countries, we estimate the model and find parameters consistent with preference for early resolution of uncertainty. Our results confirm the existence of time-varying risk premia in sovereign spreads as compensation for exposure to common U.S. macroeconomic risk.

MODELING LIFETIME EXPECTED CREDIT LOSSES ON BANK LOANS

2021 ◽  
Author(s):  
THAMAYANTHI CHELLATHURAI
Keyword(s):  
Term Structure ◽  
Financial Institution ◽  
Bank Loans ◽  
Probability Of Default ◽  
Short Term ◽  
Multiple Points ◽  
Loss Given Default ◽  
Black Scholes ◽  
Debt Repayment ◽  
Credit Losses

The guidelines of various Accounting Standards require every financial institution to measure lifetime expected credit losses (LECLs) on every instrument, and to determine at each reporting date if there has been a significant increase in credit risk since its inception. This paper models LECLs on bank loans given to a firm that has promised to repay debt at multiple points over the lifetime of the contract. The LECL can be written as a sum of ECLs (estimated at reporting date) incurred at debt repayment times. The ECL at any debt repayment time can be written as a product of the probability of default (PD), the expected value of loss given default and the exposure at default. We derive a stochastic dynamical equation for the value of the firm’s asset by incorporating the dynamics of the factors. Also, we show how the LECL and the term structure of the PD can be estimated by solving a Black–Scholes–Merton like partial differential equation. As an illustration, we present the numerical results for the various credit loss indicators of a fictitious firm when the dynamics of the short-term interest rate is characterized by a Cox–Ingersoll–Ross mean-reverting process.

scholarly journals Rating Migration and Bond Valuation: Towards Ahistorical Rating Migration Matrices and Default Probability Term Structures

2019 ◽  
Vol 5 (1) ◽  
pp. 12
Author(s):  
Brian Barnard
Keyword(s):  
Term Structure ◽  
Cash Flows ◽  
Default Probability ◽  
Reduced Form ◽  
Probability Of Default ◽  
Forward Rates ◽  
Bond Valuation ◽  
Term Structures ◽  
Probability Term ◽  
The Impact

The study examines rating migration, and default probability term structures obtained from rating migration matrices. It expands on the use of rating migration matrices with reduced form bond valuation models, by formally delineating the probability of default according to the likely rating paths of a bond, as implied by the rating migration matrix. Further, two alternatives are also considered. First, the cost of default is stipulated as the recovery of par according to the exit rating upon default. Also, in addition to stating the value of a bond in terms of expected cash flows, when considering the probability of default, the value of a bond is alternatively stated as the present value of all likely rating paths of the bond, discounted against the market risk-bearing bond forward rates of the different rating categories. The impact of term structure volatility and rating migration uncertainty on bond valuation is also considered.It is shown that the relationship between rating migration and default probability is complex, and the default probabilities of different rating categories are time-dependent and not isolated from each other. Also, rating migration resembles a delayed default process that influences default probabilities of subsequent intervals. The implications of a rating migration matrix may perhaps only be fully understood through simulation. This form one of the first points by which to evaluate rating migration matrices. The results of the valuation model show that historical rating migration matrices may not be optimal for pricing bonds ahistorically. A principal premise of the study is the dichotomy between historical values and ahistorical estimates, particularly with regards to rating migration. It is argued that historical estimates face two key shortcomings: they must be able to accurately forecast future rating migration and rating category intensities as a result, and they must specify a method to include rating migration uncertainty. An optimization model is delineated to extract ahistorical rating migration matrices from market prices. This too has implications that should be considered. In light of the above, reduced form models may have an advantage over structural models, in their ability to portray a far more sophisticated default process.

COUNTERPARTY RISK FOR CREDIT DEFAULT SWAP WITH STATES RELATED DEFAULT INTENSITY PROCESSES

2011 ◽  
Vol 14 (08) ◽  
pp. 1335-1353 ◽  
Author(s):  
DAN TANG ◽  
YONGJIN WANG ◽  
YUZHEN ZHOU
Keyword(s):  
Markov Chains ◽  
Credit Default Swap ◽  
Reduced Form ◽  
Counterparty Risk ◽  
Default Correlation ◽  
Default Intensity ◽  
Credit Default ◽  
Form Model ◽  
Default Swap ◽  
Set Up

In this paper, the counterparty risk is considered in pricing a Credit Default Swap (abbr. CDS). We adopt an intensity-based reduced form model, in which the default intensity processes of the counterpart and the reference credit are modulated by the credit states of the firms. Two Markov chains are used to describe the credit state processes. We set up a model where the default correlation between the counterpart and the reference is described through the Markov chains. A semi-explicit formula for the pricing of CDS with counterparty risk is obtained. We analyze the impacts of default correlations and the state changes on the CDS price through some numerical experiments.

The signalling properties of the shape of the credit default swap term structure

2015 ◽  
Vol 17 (4) ◽  
pp. 71-99 ◽  
Author(s):  
Jenny Castellanos ◽  
Nick Constantinou ◽  
Wing Lon Ng
Keyword(s):  
Term Structure ◽  
Credit Default Swap ◽  
Credit Default ◽  
Default Swap
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