On Pricing Credit Default Swaps with Observable Covariates
49 Pages Posted: 2 Jul 2011 Last revised: 16 Mar 2012
Date Written: June 7, 2011
Observable covariates are useful for predicting default under the natural measure, but several findings question their value for explaining credit spreads under the pricing measure. We introduce a discrete time no-arbitrage model with observable covariates, which allows for a closed form solution for the value of credit default swaps (CDS). The default intensity is a quadratic function of the covariates, specified such that it is always positive. The model yields economically sensible results in terms of fit, economic impact of coefficients, and statistical significance. Macroeconomic and firm-specific information can explain most of the variation in CDS spreads over time and across firms, even with a parsimonious specification. These findings resolve the existing disconnect in the literature regarding the value of observable covariates for credit risk pricing and default prediction. Our results also suggest that although CDS spreads are highly auto-correlated, analyzing spread levels may be preferable to analyzing differences for daily CDS data.
Keywords: credit default swap, no-arbitrage, observable covariates, volatility, leverage, distance-to-default
JEL Classification: G12
Suggested Citation: Suggested Citation