# The determinants of CDS spreads: evidence from the model space

Article

First Online:

- 165 Downloads
- 1 Citations

## Abstract

We apply Bayesian model averaging and a frequentistic model space analysis to assess the pricing determinants of credit default swaps (CDSs). Our study focuses on the complete model space of plausible models and thus supports ultimate robustness. Using a large dataset of CDS contracts we find that CDS price dynamics can be mainly explained by factors describing firms’ sensitivity to extreme market movements. More precisely, our results suggest that dynamic copula based measures of tail dependence incorporate most essential pricing information, making other potential determinants such as Merton-type factors or linear variables measuring the systematic market evolution negligible.

## Keywords

CDS Bayesian model averaging Crash aversion Tail risk Tail dependence Time-varying copulas## JEL Classification

G12 C11 G01## Supplementary material

## References

- Ait-Sahalia, Y., & Lo, A. W. (2000). Nonparametric risk management and implied risk aversion.
*Journal of Econometrics*,*94*, 9–51.CrossRefGoogle Scholar - Alexander, C., & Kaeck, A. (2008). Regime dependent determinants of credit default swap spreads.
*Journal of Banking & Finance*,*32*, 1008–1021.CrossRefGoogle Scholar - Andersen, T. G., Bollerslev, T., Christoffersen, P. F., & Diebold, F. X. (2006). Handbook of economic forecasting. In G. Elliott, C. W. J. Granger, & A. Timmermann (Eds.),
*Volatility and correlation forecasting*(pp. 778–878). Amsterdam: Elsevier.Google Scholar - Arakelyan, A., Rubio, G., & Serrano, P. (2015). The reward for trading illiquid maturities in credit default swap markets.
*International Review of Economics and Finance*,*39*, 376–389.CrossRefGoogle Scholar - Augustin, P., Subrahmanyam, M. G., Tang, D. Y., & Wang, S. Q. (2014). Credit default swaps—A survey.
*Foundations and Trends in Finance*,*9*, 1–196.CrossRefGoogle Scholar - Augustin, P., & Tédongap, R. (2011).
*Common factors and commonality in sovereign CDS spreads: A consumption-based explanation*. Working paper.Google Scholar - Avramov, D. (2002). Stock return predictability and model uncertainty.
*Journal of Financial Economics*,*64*, 423–458.CrossRefGoogle Scholar - Baele, L., De Bruyckere, V., De Jonghe, O., & Vander Vennet, R. (2015). Model uncertainty and systematic risk in US banking.
*Journal of Banking & Finance*,*53*, 49–66.CrossRefGoogle Scholar - Bauwens, L., Laurent, S., & Rombouts, J. (2006). Multivariate GARCH models: A survey.
*Journal of Applied Econometrics*,*21*, 79–109.CrossRefGoogle Scholar - Benkert, C. (2004). Explaining credit default swap premia.
*The Journal of Futures Markets*,*24*, 71–92.CrossRefGoogle Scholar - Berg, D. (2009). Copula goodness-of-fit testing: An overview and power comparison.
*European Journal of Finance*,*15*, 675–701.CrossRefGoogle Scholar - Berndt, A., & Obreja, I. (2010). Decomposing European CDS returns.
*Review of Finance*,*14*, 189–233.CrossRefGoogle Scholar - Bollerslev, T., & Todorov, V. (2011). Tails, fears, and risk premia.
*The Journal of Finance*,*66*, 2165–2211.CrossRefGoogle Scholar - Bollerslev, T., Todorov, V., & Xu, L. (2015). Tail risk premia and return predictability.
*Journal of Financial Economics*,*118*, 113–134.CrossRefGoogle Scholar - Bongaerts, D., de Jong, F., & Driessen, J. (2011). Derivate pricing with liquidity risk: Theory and evidence from the credit default swap market.
*The Journal of Finance*,*66*, 203–240.CrossRefGoogle Scholar - Breusch, T. (1978). Testing for autocorrelation in dynamic linear models.
*Australian Economic Papers*,*17*, 334–355.CrossRefGoogle Scholar - Bujack, K. M., & Santamaria, M. T. C. (2016).
*Credit default swaps and financial risks in the 21st century*. Working paper.Google Scholar - Buocher, C., Daníelsson, J., Kouontchoub, P., & Mailleta, B. (2014). Risk models-at-risk.
*Journal of Banking & Finance*,*44*, 72–92.CrossRefGoogle Scholar - Burnham, K . P., & Anderson, D . R. (2002).
*Model selection and multimodel inference: A practical information-theoretic approach*. Berlin: Springer.Google Scholar - Chabi-Yo, F., Ruenzi, S., & Weigert, F. (2014).
*Crash sensitivity and the cross-section of expected stock returns*. Working paper.Google Scholar - Chen, X., & Fan, Y. (2006). Estimation and model selection of semiparametric copula-based multivariate dynamic models under copula misspecification.
*Journal of Econometrics*,*135*, 307–335.CrossRefGoogle Scholar - Chen, X., Fan, Y., & Tsyrennikov, V. (2006). Efficient estimation of semiparametric multivariate copula models.
*Journal of the American Statistical Association*,*101*, 1228–1240.CrossRefGoogle Scholar - Christoffersen, P., Errunza, V., Jacobs, K., & Langlois, H. (2012). Is the potential for international diversification disappearing? A dynamic copula approach.
*The Review of Financial Studies*,*25*, 3711–3751.CrossRefGoogle Scholar - Christoffersen, P., Jacobs, K., Jin, X., & Langlois, H. (2014).
*Dynamic dependence and diversification in corporate credit*. Working paper.Google Scholar - Clark, T., & McCracken, M. (2001). Tests for equal forecast accuracy and ecompassing for nested models.
*Journal of Econometrics*,*105*, 85–110.CrossRefGoogle Scholar - Clayton, D. (1978). A model for association in bivariate life tables and its application in epidemiological studies of familial tendency in chronic disease incidence.
*Biometrika*,*65*, 141–151.CrossRefGoogle Scholar - Collin-Dufresne, P., Goldstein, R. S., & Martin, J. S. (2001). The determinants of credit spread changes.
*The Journal of Finance*,*61*, 2177–2207.CrossRefGoogle Scholar - Cont, R. (2001). Empirical properties of asset returns: Stylized facts and statistical issues.
*Quantitative Finance*,*1*, 223–236.CrossRefGoogle Scholar - Cont, R., & Kan, Y. H. (2011).
*Statistical modeling of credit default swap portfolios*. SSRN working paper.Google Scholar - Coval, J. D., Jurek, J. W., & Stafford, E. (2009). Economic catastrophe bonds.
*American Economic Review*,*99*, 628–666.CrossRefGoogle Scholar - Creal, D., Koopman, S. J., & Lucas, A. (2013). General autoregressive score models with applications.
*Journal of Applied Econometrics*,*28*, 777–795.CrossRefGoogle Scholar - Cremers, K. M. (2002). Stock return predictability: A Bayesian model selection perspective.
*Review of Financial Studies*,*15*, 1223–1249.CrossRefGoogle Scholar - Daníelsson, J. (2008). Blame the models.
*Journal of Financial Stability*,*4*, 321–328.CrossRefGoogle Scholar - Demarta, S., & McNeil, A. J. (2005). The t copula and related copulas.
*International Statistical Review*,*73*, 111–129.CrossRefGoogle Scholar - Derman, E. (1996).
*Model risk*. Goldman Sachs Quantitative Strategies Research Notes.Google Scholar - Diebold, F., Hahn, J., & Tay, A. (1999). Multivariate density forecast evaluation and calibration in financial risk management: High frequency returns on foreign exchange.
*Review of Economics and Statistics*,*81*, 661–673.CrossRefGoogle Scholar - Diebold, F., & Mariano, R. (1995). Comparing predicitve accuracy.
*Journal of Business and Economic Statistics*,*13*, 253–263.Google Scholar - Elliott, G., Gargano, A., & Timmermann, A. (2013). Complete subset regressions.
*Journal of Econometrics*,*177*, 357–373.CrossRefGoogle Scholar - Ericsson, J., Jacobs, K., & Oviedo, R. (2009). The determinants of credit default swap premia.
*Journal of Financial and Quantitative Analysis*,*44*, 109–132.CrossRefGoogle Scholar - Fernandez, C., Ley, E., & Steel, M. F. (2001). Benchmark priors for Bayesian model averaging.
*Journal of Econometrics*,*100*, 381–427.CrossRefGoogle Scholar - Frahm, G., Junker, M., & Schmidt, R. (2005). Estimating the tail-dependence coefficient: Properties and pitfalls.
*Insurance: Mathematics and Economics*,*37*, 80–100.Google Scholar - Furnival, G., & Wilson, R. (1974). Regression by leaps and bounds.
*Technometrics*,*16*, 499–511.CrossRefGoogle Scholar - Gârleanu, N., Pedersen, L. H., & Poteshman, A. M. (2009). Demand-based option pricing.
*Review of Financial Studies*,*22*, 4259–4299.CrossRefGoogle Scholar - Garratt, A., Lee, K., Pesaran, M. H., & Shin, Y. (2003). Forecast uncertainties in macroeconomic modeling.
*Journal of the American Statistical Association*,*98*, 829–838.CrossRefGoogle Scholar - Genest, C., Gendron, M., & Bourdeau-Brien, M. (2009). The advent of copulas in finance.
*The European Journal of Finance*,*15*, 609–618.CrossRefGoogle Scholar - Genest, C., Ghoudi, K., & Rivest, L.-P. (1995). A semiparametric estimation procedure of dependence parameters in multivariate families of distributions.
*Biometrika*,*82*, 543–552.CrossRefGoogle Scholar - Genest, C., & Rivest, L.-P. (1993). Statistical inference procedures for bivariate Archimedean copulas.
*Journal of the American Statistical Association*,*88*, 1034–1043.CrossRefGoogle Scholar - Godfrey, L. (1978). Testing against general autoregressive and moving average error models when the regressors include lagged dependent variables.
*Econometrica*,*46*, 1293–1302.CrossRefGoogle Scholar - Gourio, F. (2011).
*Credit risk and disaster risk*. NBER working paper 17026.Google Scholar - Green, T. C., & Figlewski, S. (1999). Market risk and model risk for a financial institution writing options.
*The Journal of Finance*,*54*, 1465–1499.CrossRefGoogle Scholar - Greene, W . H. (2003).
*Econometric analysis*(5th ed.). Upper Saddle River: Prentice Hall.Google Scholar - Gumbel, E. (1960). Distributions des valeurs extrémes en plusiers dimensions.
*Publications de l’Institut de Statistique de l’Université de Paris*,*9*, 171–173.Google Scholar - Han, N., & Zhou, Y. (2015). Understanding the term structure of credit default swap spreads.
*Journal of Empirical Finance*,*31*, 18–35.CrossRefGoogle Scholar - Han, Y., Gong, P., & Zhou, X. (2015). Correlations and risk contagion between mixed assets and mixed-asset portfolio VaR measurements in a dynamic view: An application based on time varying copula models.
*Physica A*,*444*, 940–953.CrossRefGoogle Scholar - Hansen, B. E. (2007). Least squares model averaging.
*Econometrica*,*75*, 1175–1189.CrossRefGoogle Scholar - Hansen, P. R., Lunde, A., & Nason, J. M. (2011). The model confidence set.
*Econometrica*,*79*, 453–497.CrossRefGoogle Scholar - Hasan, I., Horvath, R., & Mares, J. (2016).
*What type of finance matters for growth? Bayesian model averaging evidence*. World bank policy research working paper, 7645.Google Scholar - Hastie, T., Tibshirani, R., & Friedman, J. (2008).
*The elements of statistical learning*(2nd ed.). Heidelberg: Springer.Google Scholar - Heinz, F. F., & Sun, Y. (2014).
*Sovereign CDS spreads in Europe—The role of global risk aversion, economic fundamentals, liquidity, and spillovers*. IMF working paper.Google Scholar - Hoerl, A., & Kennard, R. (1970). Ridge regression: Biased estimation for nonorthogonal problems.
*Technometrics*,*12*(1), 55–67.CrossRefGoogle Scholar - Hoeting, J. A., Madigan, D., Raftery, A. E., & Volinsky, C. T. (1999). Bayesian model averaging: A tutorial.
*Statistical Science*,*14*(4), 382–417.CrossRefGoogle Scholar - Hull, J., & Suo, W. (2002). A methodology for assessing model risk and its application to the implied volatility function model.
*The Journal of Financial and Quantitative Analysis*,*37*, 297–318.CrossRefGoogle Scholar - Jackwerth, J. C., & Rubinstein, M. (1996). Recovering probability distributions from option prices.
*The Journal of Finance*,*51*, 1611–1631.CrossRefGoogle Scholar - Joe, H. (1997).
*Multivariate models and dependence concepts*. London: Chapman & Hall.CrossRefGoogle Scholar - Joe, H. (2015).
*Dependence modelling with copulas*. Boca Raton: CRC Press.Google Scholar - Jondeau, E., & Rockinger, M. (2006). The Copula-GARCH model of conditional dependencies: An international stock market application.
*Journal of International Money and Finance*,*25*, 827–853.CrossRefGoogle Scholar - Jorion, P., & Zhang, G. (2007). Good and bad credit contagion: Evidence from credit default swaps.
*Journal of Financial Economics*,*84*, 860–883.CrossRefGoogle Scholar - Kapetanios, G., Labhard, V., & Price, S. (2008). Forecasting using bayesian and information theoretic model averaging: An application to UK inflation.
*Journal of Business and Economic Statistics*,*26*, 33–41.CrossRefGoogle Scholar - Kass, R., & Raftery, A. (1995). Bayes factors.
*Journal of the American Statistical Association*,*90*, 773–795.CrossRefGoogle Scholar - Keiler, S., & Eder, A. (2013).
*CDS spreads and systemic risk—A spatial econometric approach*. Discussion paper Deutsche Bundesbank.Google Scholar - Kita, A. (2015).
*Predicting credit default swap spreads: The role of credit spread volatility*. Working paper.Google Scholar - Kole, E., Koedijk, K., & Verbeek, M. (2006).
*Selecting copulas for risk management*. Working paper.Google Scholar - Koziol, C., Koziol, P., & Schön, T. (2015). Do correlated defaults matter for CDS premia? An empirical analysis.
*Review of Derivatives Research*,*18*, 191–224.CrossRefGoogle Scholar - Kullback, S., & Leibler, R. (1951). Oeconometrics and sufficency.
*Annals of Mathematical Statistics*,*22*, 79–86.CrossRefGoogle Scholar - Kumar, A., & Lee, C. M. (2006). Retail investor sentiment and return comovements.
*The Journal of Finance*,*61*, 2451–2486.CrossRefGoogle Scholar - Laeven, L., & Valencia, F. (2012).
*Systemic banking crises database: An update*. IMF working paper.Google Scholar - Li, D. X. (2000).
*On default correlation: A copula function approach*. The RiskMetrics Group working paper, 99-07.Google Scholar - Longstaff, F. A., Mithal, S., & Neis, E. (2005). Corporate yield spreads: Default risk or liquidity? New evidence from the credit default swap market.
*The Journal of Finance*,*60*, 2213–2253.CrossRefGoogle Scholar - Madigan, D., & Raftery, A. (1994). Model selection and accounting for model uncertainty in graphical models using occam’s window.
*Journal of the American Statistical Association*,*89*, 1535–1546.CrossRefGoogle Scholar - Madigan, D., & York, J. (1995). Bayesian graphical models for discrete data.
*International Statistical Review*,*63*, 215–232.CrossRefGoogle Scholar - Meine, C., Supper, H., & Weiß, G. N. (2015). Do CDS spreads move with commonality in liquidity?
*Review of Derivatives Research*,*18*, 225–261.CrossRefGoogle Scholar - Meine, C., Supper, H., & Weiß, G. N. (2016). Is tail risk priced in credit default swap premia?
*Review of Finance*,*20*, 287–336.CrossRefGoogle Scholar - Merton, R. C. (1974). On the pricing of corporate debt: The risk structure of interest rates.
*The Journal of Finance*,*29*, 449–479.Google Scholar - Moral-Benito, E. (2012). Determinants of economic growth: A Bayesian panel data approach.
*Review of Economics and Statistics*,*94*, 566–579.CrossRefGoogle Scholar - Moral-Benito, E. (2015). Model averaging in economics: An overview.
*Journal of Economic Surveys*,*29*, 46–75.CrossRefGoogle Scholar - Nickell, S. (1981). Biases in dynamic models with fixed effects.
*Econometrica*,*49*, 1417–1426.CrossRefGoogle Scholar - Oh, D. H., & Patton, A. J. (2013).
*Time-varying systemic risk: Evidence from a dynamic copula model of CDS spreads*. Economic Research Initiatives at Duke (ERID) working paper.Google Scholar - Patton, A. J. (2006). Modelling asymmetric exchange rate dependence.
*International Economic Review*,*47*, 527–556.CrossRefGoogle Scholar - Patton, A. J. (2009). Handbook of financial time series. In T. G. Andersen, R. A. Davis, J.-P. Kreiss, & T. V. Mikosch (Eds.),
*Copula-based models for financial time series*. Berlin: Springer.CrossRefGoogle Scholar - Qiu, J., & Yu, F. (2012). Endogenous liquidity in credit derivatives.
*Journal of Financial Economics*,*103*, 611–631.CrossRefGoogle Scholar - Raftery, A. E., Madigan, D., & Hoeting, J. A. (1997). Bayesian model averaging for linear regression models.
*Journal of the American Statistical Association*,*92*, 179–191.CrossRefGoogle Scholar - Rémillard, B. (2010).
*Goodness-of-fit tests for copulas of multivariate time series*. Working paper.Google Scholar - Rosenblatt, M. (1952). Remarks on a multivariate transformation.
*The Annals of Mathematical Statistics*,*23*, 470–472.CrossRefGoogle Scholar - Rubinstein, M. (1994). Implied binomial trees.
*The Journal of Finance*,*49*, 771–818.CrossRefGoogle Scholar - Sala-I-Martin, X., Doppelhofer, G., & Miller, R. I. (2004). Determinants of long-term growth: A Bayesian averaging of classical estimates (BACE) approach.
*The American Economic Review*,*94*, 813–835.CrossRefGoogle Scholar - Samuels, J. D., & Sekkel, R. M. (2011).
*Forecasting with large datasets: Trimming predictors and forecast combination*. Technical report, working paper.Google Scholar - Sklar, A. (1959). Fonctions de répartition à n dimensions et leurs marges.
*Publications de l’Institut Statistique de l’Université de Paris*,*8*, 229–231.Google Scholar - Tang, D. Y., & Yan, H. (2008).
*Liquidity and credit default swap spreads*. SSRN working paper.Google Scholar - Tibshirani, R. (1996). Regression shrinkage and selection via the lasso.
*Journal of the Royal Statistical Society Series B*,*58*(1), 267–288.Google Scholar - Volinsky, C., Madigan, D., Raftery, E., & Kronmal, R. (1997). Bayesian model averaging in proportional hazard models: Assessing the risk of a stroke.
*Applied Statistics*,*46*, 433–448.Google Scholar - Weiß, G. N., & Scheffer, M. (2015). Mixture pair-copula-constructions.
*Journal of Banking & Finance*,*54*, 175–191.CrossRefGoogle Scholar - Wooldridge, J. (2003). Cluster-sample methods in applied econometrics.
*American Economic Review*,*93*, 133–138.CrossRefGoogle Scholar - Wright, J. H. (2008). Bayesian model averaging and exchange rate forecasts.
*Journal of Econometrics*,*146*, 329–341.CrossRefGoogle Scholar - Wright, J. H. (2009). Forecasting US inflation by Bayesian model averaging.
*Journal of Forecasting*,*28*, 131–144.CrossRefGoogle Scholar - Zhang, B. Y., Zhou, H., & Zhu, H. (2009). Explaining credit default swap spreads with the equity volatility and jump risks of individual firms.
*The Review of Financial Studies*,*22*, 5099–5131.CrossRefGoogle Scholar - Zou, H., & Hastie, T. (2005). Regularization and variable selection via the elatic net.
*Journal of the Royal Statistical Society*,*67*, 301–320.CrossRefGoogle Scholar

## Copyright information

© Springer Science+Business Media, LLC 2017