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Single-Name Credit Default Swaps: a Review of the Empirical Academic Literature*

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Single-Name Credit Default Swaps: a Review of the Empirical Academic Literature* Single-name Credit Default Swaps: A Review of the Empirical Academic Literature* By Christopher L. Culp, Ph.D. Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise Swiss Finance Institute Risk Management Consulting Services, Inc. Compass Lexecon Andria van der Merwe, Ph.D. Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise Compass Lexecon and Bettina J. Stärkle, M.Sc. Risk Management Consulting Services, Inc. Compass Lexecon September 2016 * We are grateful to Aaron Brown, Steven Kennedy, Andrea Neves, Mark New, Janusz Ordover, Fred Quenzer, and Pietro Veronesi for their comments on earlier drafts. We also thank Natalie Calloway, George Cassidy, Harris Rothman, and Vonda Versical for their capable research assistance and Debbie Zimmermann for her supervision of our research assistants. Nevertheless, the usual caveat applies, and the views and opinions we express herein (along with any remaining errors) are ours and ours alone and do not necessarily represent the views of ISDA, Risk Management Consulting Services, Inc., Compass Lexecon (and FTI Consulting, Inc., the parent company of Compass Lexecon), or any or their customers and clients. Please address correspondence to [email protected]. CONTENTS CONTENTS ................................................................................................................. II EXECUTIVE SUMMARY ............................................................................................. V ABBREVIATIONS AND ACRONYMS ......................................................................... XIV I. INTRODUCTION ................................................................................................1 A. Background and Motivation ......................................................................................... 1 B. Scope of Review ........................................................................................................... 3 1. Selection Criteria ........................................................................................................ 3 2. Citation Style and Underlying Data Sources .............................................................. 4 C. Structure of the Paper.................................................................................................... 4 D. Sponsorship of the Review and Disclaimers ................................................................ 6 II. BACKGROUND ON SINGLE-NAME CDSS ......................................................... 7 A. The Composition of the CDS Market ........................................................................... 7 1. Aggregate CDS Market Activity................................................................................. 7 2. Single-Name CDSs by Type of Underlying ............................................................. 10 B. Significant Contract Terms and Trading Conventions ............................................... 11 1. Reference Entity ........................................................................................................ 11 a) Type of Reference Entity ............................................................................................ 11 b) Credit Risk of Reference Entity .................................................................................. 14 2. Maturity/Tenor .......................................................................................................... 15 3. Coupon/Spread .......................................................................................................... 17 4. Credit Events ............................................................................................................. 18 a) The 1999 and 2003 Definitions................................................................................... 19 b) The 2009 “Big Bang Protocol” and Supplement to the 2003 Definitions .................. 20 c) Example of the Determinations Process: The Hellenic Republic Credit Event .......... 22 d) The 2014 Definitions .................................................................................................. 26 5. Settlement Methods .................................................................................................. 27 a) Physical Settlement ..................................................................................................... 27 b) Auction Settlement ...................................................................................................... 29 c) Cash Settlement .......................................................................................................... 31 6. Deliverable Obligations ............................................................................................ 32 III. POTENTIAL BENEFITS AND COSTS OF SINGLE-NAME CDSS ....................... 34 A. Potential Benefits of Single-Name CDSs ................................................................... 34 1. Credit Risk Transfer .................................................................................................. 34 a) Managing Realized Default Risk ................................................................................ 35 ii b) Managing Interim Mark-to-Market Risk .................................................................... 35 2. Increased Supply of Loanable Funds ........................................................................ 36 3. Synthetic Bond Investments ..................................................................................... 36 4. Price Discovery and Information Aggregation ......................................................... 36 B. Potential Costs of Single-Name CDSs ........................................................................ 37 1. Increased Risk-Taking and Diminished Monitoring by Banks ................................. 37 2. Empty Creditors and Negative Economic Interests .................................................. 37 3. “Excessive” Volatility Arising from Speculation ..................................................... 38 4. Systemic Risk ............................................................................................................ 39 IV. THE INFORMATIONAL CONTENT OF CDS SPREADS .................................... 40 A. Reference Entity Credit Risk ...................................................................................... 40 1. CDS Spreads and the Greek Restructuring Event ..................................................... 40 2. CDS Spreads and the Lehman Credit Event ............................................................. 42 B. Determinants of CDS Spreads .................................................................................... 43 1. CDS Spreads and Expected Credit Losses ................................................................ 44 2. The Term Structure of CDS Spreads ........................................................................ 45 3. Determinants of CDS Risk Premiums ...................................................................... 47 a) Reference Entity-Specific Risks ................................................................................. 47 b) Both Reference Entity-Specific and Systematic Risk Factors .................................... 48 c) Systematic Risk Factors .............................................................................................. 49 C. Single-Name CDS Event Studies................................................................................ 50 1. Credit Rating Actions ............................................................................................... 51 2. Spillover Effects from Adverse Credit Events .......................................................... 52 a) Corporate Reference Entities ...................................................................................... 52 b) Sovereign Reference Entities ...................................................................................... 53 3. Other Corporate Performance Announcements ........................................................ 53 4. Other Announcements and Information .................................................................... 54 V. IMPLICATIONS OF SINGLE-NAME CDS TRADING FOR CREDITORS AND CDS REFERENCE ENTITIES ...................................................................................56 A. The Impact of Single-Name CDSs on Bank Lenders ................................................. 56 1. Determinants of Bank Usage of Single-Name CDSs and Implications for Monitoring ................................................................................................................................... 56 2. Single-Name CDSs and Risk-Taking by Banks and Insurers ................................... 58 3. Single-Name CDSs and Banks’ Monitoring of Borrowers’ Credit Risks ................ 59 B. The Impact of the Availability of Single-Name CDSs on Reference Entities ............ 61 1. Impact on the Supply of Credit ................................................................................. 61 2. Impact on Reference Entity Borrowing Costs .......................................................... 62 3. Impacts on Reference Entity Corporate Financing Decisions and Capital Structure 64 4. CDS Externalities ...................................................................................................... 65 5. The Empty Creditor and Negative Interest Problems
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