Rather than assuming a fixed recovery rate in estimation, we estimate recovery rates from credit default swap spreads, using 3 years of daily data on 152 corporations. We use a quadratic pricing model, which ensures nonnegative default probabilities and recovery rates. The estimated cross section of recovery rates is plausible, with an average recovery rate of 54% and substantial cross-sectional variation. Estimated 5-year default probabilities are on average 67% higher than default probabilities obtained using the standard 40% recovery assumption. This finding critically impacts the valuation of structured credit products. Larger firms and firms with more tangible assets have higher recovery rates

We use credit default swaps (CDS) trading data to demonstrate that the credit risk of reference firms, reflected in rating downgrades and bankruptcies, increases significantly upon the inception of CDS trading, a finding that is robust after controlling for the endogeneity of CDS trading. Additionally, distressed firms are more likely to file for bankruptcy if they are linked to CDS trading. Furthermore, firms with more “no restructuring” contracts than other types of CDS contracts (i.e., contracts that include restructuring) are more adversely affected by CDS trading, and the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure in the resolution of financial distress

This paper examines the impact of central clearing on the credit default swap (CDS) market using a sample of voluntarily cleared single-name contracts. Consistent with central clearing reducing counterparty risk, CDS spreads increase around the commencement of central clearing and are lower than settlement spreads published by the central clearinghouse. Furthermore, the relation between CDS spreads and dealer credit risk weakens after central clearing begins, suggesting a lowering of systemic risk. These findings are robust to controls for frictions in both CDS and bond markets. Finally, matched sample analysis reveals that the increased post-trade transparency following central clearing is associated with an improvement in liquidity and trading activity

Minimal discounted distorted expectations across a range of stress levels are employed to model risk acceptability in markets. Interactions between discounting and stress levels used in measure changes are accommodated by lowering discount rates for the higher stress levels. Acceptability parameters represent a maximal and minimal discount rate, a maximal stress level and the speed of rate reduction in response to stress. An explicit model relating credit default swap (CDS) prices to default probabilities is formulated with a view to making the default risk market acceptable. Data on CDS prices and default probabilities for the six major US banks obtained from the Risk Management Institute of the National University of Singapore is employed to estimate parameters defining acceptability and the movements in market implied recovery rates. We observe that the financial crisis saw an increase in the maximal discount rate and its spread over the minimal rate along with an increase in the maximal stress level being demanded for acceptability and a stable pattern for the speed of rate adjustment through the period. The maximal rate, rate spread and stress levels have come down but with periods in the interim where they have peaked as they did in the crisis. Recovery rates have oscillated and they did fall substantially but have recovered towards 40 percent near the end of the period

The literature on distressed firms has focused on these firms’ investment, capital structure, and labor decisions. This paper investigates a novel aspect of firm behavior in distress: how financial health affects a firm׳s lobbying and, consequently, its relationship with the government. We exploit the shock to nonfinancial firms during the 2008 financial crisis and the availability of the stimulus package in the first quarter of 2009. We find that firms with weaker financial health, as measured by credit default swap spreads, lobbied more. We also show that the amount spent on lobbying was associated with a greater likelihood of receiving stimulus funds

This paper analyses the network structure of the credit default swap (CDS) market and its determinants, using a unique dataset of bilateral notional exposures on 642 financial and sovereign reference entities. We find that the CDS network is centred around 14 major dealers, exhibits a “small world” structure and a scale-free degree distribution. A large share of investors are net CDS buyers, implying that total credit risk exposure is fairly concentrated. Consistent with the theoretical literature on the use of CDS, the debt volume outstanding and its structure (maturity and collateralization), the CDS spread volatility and market beta, as well as the type (sovereign/financial) of the underlying bond are statistically significantly related—with expected signs—to structural characteristics of the CDS market

We study how sovereign wealth fund (SWF) investments affect the credit risk of target companies as measured by the change in their credit default swap (CDS) spreads around the investment announcement. We find that the CDS spread of target companies decreases, on average, following an SWF investment. The reduction in the CDS spread is higher when the SWF is established by a politically stable non-democratic country that has a neutral political relationship with the host country of the target company. Our results suggest that creditors expect SWFs to protect target companies from bankruptcy when it is in the interest of their home country to build political goodwill in the host country of the company

We examine the impact of credit default swaps (CDS) on lending relationships and credit market efficiency. CDS insulate lenders against losses from forcing borrowers into default and liquidation. This improves the credibility of foreclosure threats, which can have positive implications for borrower incentives and credit availability ex ante. However, lenders may also abuse their enhanced bargaining power vis-à-vis borrowers and extract excessive rents in debt renegotiations. If this hold up threat becomes severe, borrowers will be reluctant to agree to debt maturity designs or control rights transfers that would have been optimal in the absence of CDS markets. The introduction of CDS markets may then ultimately tighten credit constraints and be detrimental to welfare. Our analysis yields a number of empirical implications, some of which have been tested

We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost increases sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government guarantees and bond holdings. Using credit default swap (CDS) rates on European sovereigns and banks, we show that bailouts triggered the rise of sovereign credit risk in 2008. We document that post‐bailout changes in sovereign CDS explain changes in bank CDS even after controlling for aggregate and bank‐level determinants of credit spreads, confirming the sovereign‐bank loop

What market features of financial risk transfer exacerbate counterparty risk? To analyze this, we formulate a model which elucidates important differences between financial risk transfer and traditional insurance, using the example of Credit Default Swaps (CDS). We allow for (heterogeneous) insurer insolvency, which captures the possibility that relatively risky counterparties may exist in the market. Further, we find that stable insurers become less stable as the price of the contract decreases. The analysis includes insured parties that have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for trading purposes. We show that traders will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that removes traders can, perversely, cause stable counterparties to become less stable. We conclude with two extensions of the model that consider a Central Counterparty (CCP) arrangement and the consequences of asymmetric information over insurer type