Risk transfer in project finance loans for toll road using credit default swaps

Purpose The purpose of this paper is to demonstrate the applicability of the Credit Default Swaps (CDS), as a financial instrument, for transferring of risk in project finance loans. Also, an equation has been derived for pricing of CDS spreads. Design/methodology/approach The debt service cover ratio (DSCR) is modeled as a Brownian Motion (BM) with a power-law model fitted to the mean and half-variance of the existing data set of DSCRs. The survival probability of DSCR is calculated during the operational phase of the project finance deal, using a closed-form analytical method, and the results are verified by Monte Carlo simulation (MCS). Findings It is found that using the power-law model yields higher CDS premiums. This in turn confirms the necessity of conducting rigorous statistical analysis in fitting the best performing model as uninformed reliance on constant time-invariant drift and diffusion model can erroneously result in smaller CDS spreads. A sensitivity analysis also shows that the results are very sensitive to the recovery rate and cost of debt values. Originality/value Insufficiency of free cash flow is a major risk in the toll road project finance and hence there is a need to develop innovative financial instruments for risk management. In this paper, a novel valuation method of CDS is proposed assuming that DSCR follows the BM stochastic process.

Firm-Specific Risk-Neutral Distributions with Options and CDS

We propose a method to extract the risk-neutral distribution of firm-specific stock returns using both options and credit default swaps (CDS). Options and CDS provide information about the central part and the left tail of the distribution, respectively. Taken together, but not in isolation, options and CDS span the intermediate part of the distribution, which is driven by exposure to the risk of large, but not extreme, returns. Through a series of asset-pricing tests, we show that this intermediate-return risk carries a premium, particularly at times of heightened market stress. This paper was accepted by David Simchi-Levi, finance.

Relación dinámica entre los Credit Default Swaps y la deuda pública. Análisis en el contexto latinoamericano

Se analiza cómo los Credit Default Swaps (CDS) están relacionados con el riesgo soberano en Brasil, Chile, Colombia y México, durante el período 2010-2019. Se estiman modelos de correlación condicional dinámica (DCC) y pruebas de causalidad de Granger. Se encuentra una tendencia general decreciente en las correlaciones de los últimos años de la muestra, lo cual puede ser explicado por una mejoría en la calificación de deuda soberana y una caída en riesgo de inversión en Colombia, Chile y Brasil. Además, los resultados empíricos evidencian que los CDS tienen influencia en el comportamiento de los bonos de deuda pública.

Compressing Over-the-Counter Markets

Over-the-counter markets are at the center of the global reform of the financial system. We show how the size and structure of these markets can undergo rapid and extensive changes when participants engage in portfolio compression, which is an optimization technology that exploits multilateral netting opportunities. We find that tightly knit and concentrated trading structures, as featured by many large over-the-counter markets, are especially susceptible to reductions of notional amounts and network reconfigurations resulting from compression activities. Using a unique transaction-level data set on credit-default-swaps markets, we estimate reduction levels, suggesting that the adoption of this technology can account for a large share of the historical development observed in these markets since the global financial crisis. Finally, we test the effect of a mandate to centrally clear over the counter markets in terms of size and structure. When participants engage in both central clearing and portfolio compression with the clearinghouse, we find large netting failures if clearinghouses proliferate. Allowing for compression across clearinghouses by and large offsets this adverse effect.

Credit Default Swaps and Debt Overhang

We analyze the impact of credit default swaps (CDSs) trading on firm investment, long-term debt financing, and valuation. In our model, the firm is endowed with a real option to initiate a project and enhance its future growth. Its creditors have access to CDS contracts that hedge them against default losses. We show that CDS protection increases the firm’s pledgable income: that is, the maximum amount of debt it can raise. However, at the same time CDS protection decreases asset growth and impedes project initiation. As a result, CDS trading could reduce firm value, and the negative effects are stronger when the firm is riskier, where shareholders have stronger bargaining power, and growth opportunities are less valuable. Using simulated cross-sections of firms, we find that CDS trading increases corporate default rates and deters investment. Altogether, CDS firms tend to have a lower firm value and more volatile equity returns than non-CDS firms. This paper was accepted by Gustavo Manso, finance.