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Credit Default Swap in a Financial Portfolio: Angel Or Devil?

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Credit Default Swap in a Financial Portfolio: Angel Or Devil? Credit Default Swap in a financial portfolio: angel or devil? A study of the diversification effect of CDS during 2005-2010 Authors: Aliaksandra Vashkevich Hu DongWei Supervisor: Catherine Lions Student Umeå School of Business Spring semester 2010 Master thesis, one-year, 15 hp ACKNOWLEDGEMENT We would like to express our deep gratitude and appreciation to our supervisor Catherine Lions. Your valuable guidance and suggestions have helped us enormously in finalizing this thesis. We would also like to thank Rene Wiedner from Thomson Reuters who provided us with an access to Reuters 3000 Xtra database without which we would not be able to conduct this research. Furthermore, we would like to thank our families for all the love, support and understanding they gave us during the time of writing this thesis. Aliaksandra Vashkevich……………………………………………………Hu Dong Wei Umeå, May 2010 ii SUMMARY Credit derivative market has experienced an exponential growth during the last 10 years with credit default swap (CDS) as an undoubted leader within this group. CDS contract is a bilateral agreement where the seller of the financial instrument provides the buyer the right to get reimbursed in case of the default in exchange for a continuous payment expressed as a CDS spread multiplied by the notional amount of the underlying debt. Originally invented to transfer the credit risk from the risk-averse investor to that one who is more prone to take on an additional risk, recently the instrument has been actively employed by the speculators betting on the financial health of the underlying obligation. It is believed that CDS contributed to the recent turmoil on financial markets and served as a weapon of mass destruction exaggerating the systematic risk. However, the latest attempts to curb the destructive force of the credit derivative for the market by means of enhancing the regulation over the instrument, bringing it on the stock-exchange and solving the transparency issue might approve CDS in the face of investor who seeks to diminish the risk of his financial portfolio. In our thesis we provide empirical evidence of CDS ability to fulfil the diversification function in the portfolio of such credit sensitive claims as bonds and stocks. Our data for the empirical analysis consist of 12 European companies whose debt underlies the most frequently traded single-name CDS with the maturity of 5 years. Through multivariate vector autoregressive models we have tested the intertemporal relation between stock returns, CDS and bond spreads changes as well as the magnitude of this relation depending on the stock market state. The results we have achieved for our sample are the following: 1) stock returns are mainly negatively related to the CDS and bond spread changes; 2) stock returns are the least affected by both credit spread changes, whereas changes in bond spreads are the best explained by the stock and CDS market movements; 3) the strength of the relation between three variables differs over the time: the relationship between stock returns and CDS spreads is the most dominant during the pre and post-crisis periods, while during the financial crisis time the relation between stock returns and bond spread changes as well as that of between both credit spreads comes to the foreground. The above described relations between the three markets serve as a proof of the possibility to work out diversification strategies employing CDS. During the time of turbulence on the markets the investor may exert bigger diversification gains with the help of CDS. Thus, in spite of all the recent blame of the instrument from the investor perspective it is still remains one of the sources of profit. Keywords: credit risk, credit derivative, credit default swap, credit spreads, portfolio diversification, investor. iii TABLE OF CONTENTS 1. INTRODUCTION ...................................................................................................... 1 1.1 BACKGROUND .......................................................................................................... 1 1.2 PROBLEM DISCUSSION .............................................................................................. 2 1.3 RESEARCH QUESTION ............................................................................................... 3 1.4 RESEARCH PURPOSE ................................................................................................. 3 1.5 LIMITATIONS............................................................................................................. 3 1.6 DISPOSITION............................................................................................................. 4 1.7 GLOSSARY................................................................................................................ 4 1.7.1 Bond.................................................................................................................. 4 1.7.2 Portfolio diversification.................................................................................... 5 1.7.3 Credit rating ..................................................................................................... 5 1.7.4 Credit risk ......................................................................................................... 5 1.7.5 Hedging, Arbitrage and Speculation................................................................ 5 2. METHODOLOGICAL FRAMEWORK ................................................................. 7 2.1. AUTHORS’ BACKGROUND ........................................................................................ 7 2.2 CHOICE OF TOPIC...................................................................................................... 7 2.3 PRECONCEPTIONS..................................................................................................... 8 2.4 PERSPECTIVE OF STUDY............................................................................................ 8 2.5 RESEARCH PHILOSOPHY AND SCIENTIFIC APPROACH................................................. 9 2.6 RESEARCH METHOD ............................................................................................... 10 2.7 CLASSIFICATION OF RESEARCH OBJECTIVES AND RESEARCH DESIGN .......................11 2.8 SELECTION OF THEORIES .........................................................................................11 2.9 SELECTION OF DATABASES ......................................................................................11 2.10 ORIGIN OF SOURCES ............................................................................................. 12 2.11 CRITICISM OF SOURCES AND DATA ........................................................................ 13 3. THEORETICAL FRAMEWORK.......................................................................... 14 3.1 WHAT IS A CREDIT DERIVATIVE?.............................................................................. 14 3.2 CREDIT DERIVATIVE MARKET.................................................................................. 14 3.3 CREDIT DEFAULT SWAP ........................................................................................... 16 3.4 CDS MARKET ......................................................................................................... 18 3.5 CREDIT DEFAULT SWAP: PROS AND CONS................................................................. 20 3.6 CDS – DIVERSIFICATION EFFECT AND RISK REDUCTION.......................................... 23 3.7 LITERATURE REVIEW ON CDS RELATION TO STOCKS AND BONDS ........................... 25 3.8 HYPOTHESES .......................................................................................................... 27 4. EMPIRICAL ANALYSIS ........................................................................................ 29 4.1 DATA COLLECTION, CONDITIONS AND SAMPLE COMPOSITION ................................. 29 4.2 DATA DESCRIPTION................................................................................................. 30 4.3 HYPOTHESES TESTING AND RESULT DISCUSSION..................................................... 36 5. CONCLUSION ......................................................................................................... 45 5.1 CONCLUDING DISCUSSION ...................................................................................... 45 5.2 CONTRIBUTION TO THE EXISTING KNOWLEDGE ...................................................... 46 5.3 QUALITY CRITERIA ................................................................................................. 46 5.3.1 Validity............................................................................................................ 46 5.3.2 Reliability ....................................................................................................... 47 iv 5.4 SUGGESTION FOR FURTHER RESEARCH ................................................................... 47 6. REFERENCES ......................................................................................................... 49 v LIST OF TABLES Table 1. Firm characteristics………………....................................................................31 Table 2. Average correlation mid-2005 – April, 2010……………………………………………………………………………..……...34 Table 3. Three-dimensional VAR results for the whole period (summer 2005 – April, 2010)……………………………………………………………………………………37 Table 4. Three-dimensional VAR results for the 1st period (summer 2005 – spring 2007)……………………………………………………………………………………38
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