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The signalling properties of the shape of the credit default swap term structure

Castellanos, Jenny and Constantinou, Nick and Ng, Wing Lon (2015) 'The signalling properties of the shape of the credit default swap term structure.' Journal of Risk, 17 (4). pp. 71-99. ISSN 1465-1211

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Abstract

This paper studies the predictive power of the time-varying shape of the credit default swap (CDS) term structure to explain changes in future implied and excess implied volatility (implied volatility of the company over and above the market volatility) and therefore provide a leading sign of potential financial distress in a company. The shape of the CDS curve is captured by fitting the Nelson-Siegel model to the term structure and creating a new binary indicator (shape indicator) to distinguish between "good" and "bad" CDS curves. Applying the methodology to twenty US-traded companies from the financial and nonfinancial sectors, we find that the credit market is generally a leading indicator for movements in the volatility market during the subprime crisis. After confirming the strong link between CDSs and implied volatility markets (the average R-2 per sector between 36% and 63% is obtained using the Nelson-Siegel parameter and shape indicator), a partial F-test is executed to see if additional information is contained within the CDS markets over and above the volatility markets. For the period studied, this is the case for the majority of names, and it is particularly significant for Lehman Brothers.

Item Type: Article
Uncontrolled Keywords: credit risk; CDS term structure; Nelson-Siegel; implied volatility
Subjects: H Social Sciences > HD Industries. Land use. Labor > HD61 Risk Management
H Social Sciences > HG Finance
Q Science > QA Mathematics > QA75 Electronic computers. Computer science
Divisions: Faculty of Science and Health > Computer Science and Electronic Engineering, School of > Centre for Computational Finance and Economic Agents
Faculty of Social Sciences > Essex Business School
Depositing User: Jim Jamieson
Date Deposited: 25 Jun 2015 10:08
Last Modified: 25 Jun 2015 10:08
URI: http://repository.essex.ac.uk/id/eprint/14082

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