CDS Markets: Liquidity, Default Risk, and Correlation Risk

merged with project 11134

The project aims at getting a better understanding of the properties of CDS markets and thereby extracting information related to financial institutions and markets that is relevant for supervision. Models for CDS are designed and implemented to investigate the interrelation between CDS markets, bond markets, and equity-option markets. Three sub-projects cover liquidity, default risk, and correlation risk.

In a first phase, work has been completed, applying a state-space model to decompose bid and ask quotes of CDS into two components, fair default premium and liquidity premium. The model-generated output variables are analyzed in a difference-in-difference framework to determine how the default premium as well as the liquidity premium of protection buyers and sellers evolved during different periods of the financial crisis and to which extent they differ for financial institutions compared to non-financials.

A second paper on extracting a distress factor from CDS prices is in work. In particular, we elaborate a default model that isolates from CDS spreads a long-term and a short-term default risk factor, whereby the short-term factor can be interpreted as a measure of financial distress.

A third project is on measuring systemic risk with CDS spread data.