Are CDS spreads predictable? An analysis of linear and non-linear forecasting models

Avino, Davide and Nneji, Ogonna (2012): Are CDS spreads predictable? An analysis of linear and non-linear forecasting models.

Abstract

This paper investigates the forecasting performance for CDS spreads of both linear and non-linear models by analysing the iTraxx Europe index during the financial crisis period which began in mid-2007. The statistical and economic significance of the models’ forecasts are evaluated by employing various metrics and trading strategies, respectively. Although these models provide good in-sample performances, we find that the non-linear Markov switching models underperform linear models out-of-sample. In general, our results show some evidence of predictability of iTraxx index spreads. Linear models, in particular, generate positive Sharpe ratios for some of the strategies implemented, thus shedding some doubts on the efficiency of the European CDS index market.

• Item Type: MPRA Paper
• Language: English
• Keywords: Credit default swap spreads; iTraxx; Forecasting; Markov switching; Market efficiency; Technical trading rules
• Subjects: C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General; G - Financial Economics > G0 - General > G01 - Financial Crises

References

Alexander, C., Kaeck, A., 2008. Regime dependent determinants of credit default swap spreads. Journal of Banking and Finance 32, 1008-1021.

Benkert, C., 2004. Explaining credit default swap premia. Journal of Futures Markets 24, 71-92.

Berndt, A., Ostrovnaya, A., 2008. Do equity markets favour credit market news over options market news? Working Paper, Carnegie Mellon University.

Black, F., Cox, J., 1976. Valuing corporate securities: some effects of bond indenture provisions. Journal of Finance 31, 351-367.

Blanco, F., Brennan, S., Marsh, I.W., 2005. An empirical analysis of the dynamic relationship between investment grade bonds and credit default swaps. Journal of Finance 60, 2255-2281.

Byström, H., 2006. CreditGrades and the iTraxx CDS index market. Financial Analysts Journal 62, 65-76.

Campbell, J., Y., Taksler, G., B., 2003. Equity volatility and corporate bond yields. Journal of Finance 58, 2321-2350.

Cao, C., Yu, F., Zhong, Z., 2010. The information content of option-implied volatility for credit default swap valuation. Journal of Financial Markets 13, 321-343.

Collin-Dufresne, P., Goldstein, R.S., Martin, S.J., 2001. The Determinants of Credit Spread Changes. Journal of Finance 56, 2177-2207.

Cremers, M., Driessen, J., Maenhout, P., Weinbaum, D., 2008. Individual stock-option prices and credit spreads. Journal of Banking and Finance 32, 2706-2715.

Delianedis, G., Geske, R., 2001. The components of corporate credit spreads: default, recovery, tax, jumps, liquidity, and market factors. Working Paper 22-01, Anderson School, UCLA.

Dickey, D.A., Fuller, W.A., 1981. Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica 49, 1057-1072.

Diebold, F.X., Mariano, R., 1995. Comparing predictive accuracy. Journal of Business and Economic Statistics 13, 253-265.

Driessen, J., 2005. Is default event risk priced in corporate bonds? Review of Financial Studies 18, 165-195. 18

Elton, E.J., Gruber, M.J., Agrawal, D., Mann, C., 2001. Explaining the rate spread on corporate bonds. Journal of Finance 56, 247-277.

Eom, Y., Helwege, J., Huang, J., 2004. Structural models of corporate bond pricing: an empirical analysis. Review of Financial Studies 17, 499-544.

Ericsson, J., Jacobs, K., Oviedo, R., 2009. The determinants of credit default swap premia. Journal of Financial and Quantitative Analysis 44, 109-132.

Forte, S., Peña, J.I., 2009. Credit spreads: An empirical analysis on the informational content of stocks, bonds, and CDS. Journal of Banking and Finance 33, 2013-2025.

Hamilton, J., 1994. Time series analysis. Princeton, NJ: Princess University Press.

Hamilton, J.D., Kim, D.H., 2000. A re-examination of the predictability of economic activity using the yield spread. NBER Working Paper Series, No. 7954.

Harvey, D.I., Leybourne, S.J., Newbold, P., 1997. Testing the equality of prediction mean squared errors. International Journal of Forecasting 13, 281-291.

Houweling, P., Vorst, T., 2005. Pricing default swaps: empirical evidence. Journal of International Money and Finance 24, 1200-1225.

Huang, J.Z., Huang, M., 2003. How much of corporate-treasury yield spread is due to credit risk?: a new calibration approach. Working Paper.

Jones, E.P., Mason, S.P., Rosenfeld, E., 1984. Contingent claims analysis of corporate capital structures: an empirical investigation. Journal of Finance 39, 611-625.

Konstantinidi, E., Skiadopolous, G., Tzagkaraki, E., 2008. Can the evolution of implied volatility be forecasted? Evidence from European and US implied volatility indices. Journal of Banking and Finance 33, 2401-2411.

Leland, H., 1994. Risky debt, bond covenants and optimal capital structure. Journal of Finance 49, 1213-1252.

Leland, H., Toft, K.B., 1996. Optimal capital structure, endogenous bankruptcy, and the term structure of credit spreads. Journal of Finance 51, 987-1019.

Longstaff, F.A., Mithal, S., Neis, E., 2003. The credit-default swap market: is credit protection priced correctly? Working Paper, UCLA.

Longstaff, F.A., Mithal, S., Neis, E., 2005. Corporate yield spreads: default risk or liquidity? New evidence from the credit default swap market. Journal of Finance 60, 2213-2253.

Longstaff, F.A., Schwartz E.S., 1995. A simple approach to valuing risky and floating rate debt. Journal of Finance 50, 789-819.

Merton, R., 1974. On the pricing of corporate debt: the risk structure of interest rates. Journal of Finance 29, 449-470. 19

Norden, L., Weber, M., 2009. The co-movement of credit default swap, bond and stock markets: an empirical analysis. European Financial Management 15, 529-562.

Zhang, B.Y., Zhou, H., Zhu, H., 2009. Explaining credit default swap spreads with the equity volatility and jump risks of individual firms. Review of Financial Studies 22, 5099-5131.

Zhu, H., 2004. An empirical comparison of credit spreads between the bond market and the credit default swap market. Journal of Financial Services Research 29, 211-235.