Exploring the components of credit risk in credit default swaps [An article from: Finance Research Letters]

by F.J. Fabozzi, X. Cheng, R.R. Chen

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This digital document is a journal article from Finance Research Letters, published by Elsevier in 2007. The article is delivered in HTML format and is available in your Amazon.com Media Library immediately after purchase. You can view it with any web browser.

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In this paper, we test the influence of various fundamental variables on the pricing of credit default swaps. The theoretical determinants that are important for pricing credit default swaps include the risk-free rate, industry sector, credit rating, and liquidity factors. We suggest a linear regression model containing these different variables, especially focusing on liquidity factors. Unlike bond spreads which have been shown to be inversely related to liquidity (i.e., the greater the liquidity, the lower the spread), there is no a priori reason that the credit default swap spread should exhibit the same relationship. This is due to the economic characteristics of a credit default swap compared to a bond. Our empirical result shows that all the fundamental variables investigated have a significant effect on the credit default swap spread. Moreover, our findings suggest that credit default swaps that trade with greater liquidity have a wider credit default swap spread.

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