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Explaining Credit Default Swaps Pricing for Large Banks

Journal 34: Cass-Capco Institute Paper Series on Risk

İnci Ötker-Robe, Jiri Podpiera

The credit default swap spread appears to be a potent predictor of financial distress, however, its determinants have not yet been fully understood. This paper suggests a banking-industry-specific approach to the pricing of banks’ credit risk. It shows that the pricing of banks’ credit default swap spreads could be approximated by a risk frontier derived from portfolio theory, where banks are viewed as leveraged portfolios. The commonly applied structural credit risk model adds very little to the explanatory power of the portfolio-based approach, thereby underlying the importance of the new approach to banks’ credit risk.

The financial crises experienced in recent decades prompted efforts to identify indicators that would be helpful in predicting crises. Early detection of distress could trigger prompt interventions to take preemptive steps toward reducing the risk of a crisis. The ongoing global financial crisis has intensified these efforts, with policymakers looking for indicators and methods that could assist in a timely identification of highly vulnerable banks and banking systems. The credit default swap (CDS) spread appears to be one of the most promising indicators that can quite accurately reflect conditions in the financial sector at an early stage. Figure 1, in this article, provides some support – it shows a strong link between the CDS spread prior to an official government intervention in a bank and the extent of needed recapitalization (a form of intervention), with the CDS spread appearing to correlate positively with the size of the losses.

Notwithstanding the current usefulness of the CDS spread as a compound statistic of credit default risk, understanding its underlying pricing mechanism would permit a deeper analysis of factors behind distress and thus possibly lead to even better predictability of mounting default risks. However, to date, structural credit risk models have not satisfactorily explained variability in financial and non-financial corporate credit spreads, which has been established in the literature as the credit spread puzzle [see Duffee (1998)]. Consequently, this paper tries to address the credit spread puzzle by emphasizing specifics of the financial industry for pricing credit default risk for banks. The contribution of this paper is threefold: first, it focuses on a specific industry, large banks, unlike most of the relevant literature, which mixes industries [for instance, Collin-Dufresne et al. (2001); Blanco et al. (2005); and Ericsson et al. (2009)]; second, it formulates a testable hypothesis for pricing credit risk of large banks; and third, it tests the hypothesis on large European banks and verifies its robustness against an exhaustive set of variables. As such the findings in the paper invite new research in credit risk models for banks.

The commonly used model of credit risk is based on the value of a firm relative to its debt. In a nutshell, the more the value of a company approaches the value of its debt, the more risky the company becomes, and vice versa (i.e., measuring the distance to default). Since Merton (1974), the equity is viewed as a call option on a firm’s assets with maturity T; the equity price is the spot price and the maturing debt at time T per share is the strike price. Using equities as proxy for a company’s value, the credit default risk (corporate credit spread) is a function of the debt per share, volatility of equity price, and the risk-free interest rate. The theory can be applied to Credit Default Swaps (CDS) as well, as shown by Benkert (2004), but since CDSs are already spreads, the risk-free interest rate be-comes non-essential. The pricing of call equity options involves the same arguments, however, the volatility of the equity price is the one perceived (expected) by investors. As such it informs about the investor’s view on the future value of the company.

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