Credit Default Swaps: A Survey

Abstract

Credit default swaps (CDS) have been growing in importance in the global financial markets. However, their role has been hotly debated, in industry and academia, particularly after the credit crisis of 2008-2009 and the European sovereign crisis of 2010-2012. We review the extant literature on CDS that has accumulated over the past two decades. We divide our survey into seven topics after providing a broad overview in the introduction. The second section traces the historical development of CDS markets and provides an introduction to CDS contract definitions and conventions. The third section discusses the pricing of CDS, from the perspective of no-arbitrage principles as well as from that of structural and reduced-form credit risk models. It also summarizes the literature on the determinants of CDS spreads, with a focus on the role of fundamental credit risk factors, liquidity and counterparty risk. The fourth section discusses how the development of the CDS market has affected the characteristics of the related bond and equity markets, with an emphasis on the closely related concepts of market efficiency, price discovery, information flow and liquidity. Attention is also paid to the CDS-bond basis, the wedge between the pricing of the CDS and its reference bond, and the mispricing between the CDS and the equity market, which leads to a discussion on capital structure arbitrage. The fifth section examines the effect of CDS trading on firms' credit and bankruptcy risk, and how it affects corporate financial policy, including bond issuance, capital structure, liquidity management, and both external and internal corporate governance. The sixth section summarizes the literature that takes into account how CDS may impact the incentives of the various agents in the economy and the associated impact on the pricing of the contracts. In particular, we examine how CDS may alter the debtor-creditor relationship. Section seven reviews the growing literature on sovereign CDS and highlights the major conceptual and contractual differences between the sovereign and corporate CDS markets. In section eight, we discuss CDS indices, especially the role of synthetic CDS index products backed by residential mortgage-backed securities during the financial crisis. We close with our suggestions for promising future research directions on CDS contracts and markets.

Measuring Sovereign Contagion in Europe

“…5 Our paper complements and extends this literature by investigating the degree of co-movement among sovereign bond spreads (and sovereign CDSs) after controlling 4 For example, see Kamin and von Kleist (1999), Eichengreen and Mody (2000), Mauro, Sussman, and Yafeh (2002), Pan and Singleton (2008), Longstaff, Pan, Pedersen and Singleton (2011) Ang and Longstaff (2011) and Augustin (2013). This body of works shows that the most significant variables for CDS spreads are the US stock and high-yield market returns as well as the volatility risk premium embedded in the VIX index (for a survey on CDS literature see Augustin et al (2014)). Moreover, using a broad panel of bank and sovereign CDS data, Acharya, Drechsler and Schnabl (2011) concentrate on the financial sector bailouts and show that bank and sovereign credit risk are intimately linked.…”

The Determinants of CDS Spreads: Evidence from the Model Space

“…The literature on CDS spreads and its determinants is rich, and covering all contributions would exceed the scope of this paper. For a more thorough review of the literature on CDS spreads the reader is referred to Augustin et al (2014) for a recent survey.…”

Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default

“…The firms know the true probability over the high and low cash-flow states, but this is unobservable. 3 We assume a portion of the cash flows from production are not pledgeable so that production generates positive profits and control rents. Debt financing comes from investors with heterogeneous beliefs about the probability of the future states.…”