Presentation Transcript

1. Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads -- Jun Pan and Kenneth J. Singleton (Oct., 2008)

   Xue (Cindy) Hu 9/26/2013
2. Agenda Introduction The Structure of Sovereign CDS Market Pricing Sovereign CDS Contracts Separately Identify L Q and λQ The Maximum Likelihood (ML) Estimates of λQ Priced Risks in Sovereign CDS Markets
3. Introduction Definition Settlement Physical delivery of an admissible bond Term sheets: Obligation acceleration; failure to pay; restructuring; repudiation/moratorium Figure: wiki
4. Example: Source: Bloomberg
5. CDS on corporate bonds Recall John Paulson and Michael Burry European sovereign debt crisis A combination of factors December 1, 2011 the European Parliament has banned naked CDS on sovereign debts. Debate in reconstruction of Greek Sovereign debt – trigger CDS payments Countries that we will study: Korea, Turkey, and Mexico Global Recession Banks and Corporate CDS Easy Credit: Risk Lending Global Financial Crisis Earl 1990s 2002-2008 2007-2012 2008-2012
6. Example: Source: Bloomberg
7. I. The Structure of Sovereign CDS Market Compare liquidity of CDS market and bond market Lower volume Higher liquidity for bonds with a boarder range of maturities CDS spreads versus bond spreads Darrell Duffie and Jun Liu 2001, Duffie and Singleton 2003;
8. (Continued) Sample Periods for the paper: March 19, 2001 through August 10, 2006. Korea, Turkey, and Mexico Geographically dispersed Latin American, Eastern Europe, and Asia A broad range of credit quality Ratings of the three countries throughout the sample periods Regional representative Relative liquidity Liquidity of the cash market and CDS market Compare CDS prices across different countries Compare CDS prices across different maturities Compare CDS bid-ask spreads across different countries Compare CDS bid-ask spreads across different maturities
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11. (Continued) Figure 2. CDS Spreads: Mexico (upper), Turkey (left), and Korea (right), mid-market quotes.
12. (Continued) Co-movement: Co-movement of 1, 3, 5, and 10 years CDS Principal component analysis: First PC explains over 96% of the variation for all three countries except 1-year Mexico CDS (90%) Motivation for using one-factor model (Later in IV.B) Persistent upward sloping trend Mexico: the spread between 1 and 5 year is 112 bps on average Turkey: 5- and 1-year CDS spreads were -250 basis points on March 29, 2001, -150 basis points on July 10, 2002, and -200 basis points on March 24, 2003. Why is the negative spread for Turkey? Domestic election Fall of Cyprus
13. II. Pricing Sovereign CDS Contracts At issue, a CDS contract with semi-annual premium payments is priced as (see, e.g., Duffie and Singleton (2003)): Recall the ISDA term sheet and the four types of credit events:
14. L Q and λQ Now we have the arrival rate, what is the LQ ? Set L Q = .75 Recoveries estimated by agencies For example, Moody's (2003) estimates of the recoveries (weighted by issues sizes) on several recent sovereign defaults are: Argentina 28%, Ecuador 45%, Moldova 65%, Pakistan 48%, and Ukraine 69%. Set L Q = LQ ? At practical level: Set L = .75 and bootstrap λQ or use a one-factor parametric model for the λQprocess to match a day’s cross-section of spreads Question: Can L Q and the conditional Q distribution of λQ be separately identified from a time-series of market-provided spreads on newly issued CDS contracts?
15. III. Separately Identify L Q and λQ Fractional recovery of market value convention (RMV) introduced by Duffie and Singleton (1999), with fixed y = L Q X λQ Fractional recovery of face value (RFV) (see Duffie (1998) and Duffie and Singleton (1999))
16. (Continued) The spreads clearly depend on LQ and their sensitivity to changes in L Q differs across maturities. This is to be contrasted against the RMV pricing framework in equation (7), un der which the sensitivity of a defaultablebond to variation in L Q is zero with fixed y = L Q X λQ
17. (Continued) Econometric identification may be sensitive to the choice of parameter values: Fixing L= .75, price is sensitive to the volatility and mean reversion.
18. Monte Carlo to simulate L Q Monte Carlo and Maximum Likelihood (simulate 100 times) Simulate affine model for 1, 3, 5, and 10 year CDS spreads Then, add normally distributed errors Use the resulting CDS to construct maximum likelihood estimates of the underlying parameters
19. IV. The Maximum Likelihood (ML) Estimates of λQ Approach I: Fixed L Q of .75 by market convention An extensive Monte Carlo analysis of the small-sample distributions of various moments reveals that many features of the implied distributions of CDS spreads for Mexico and Turkey are similar across the cases of L Q equal to 0.75 or 0.25. For our model formulation and sample ML estimates, it is only over long horizons - for most of our countries, longer than our sample periods - that the differences in P-mean reversion in the two cases manifest themselves. Approach II: L Q as a free parameter The likelihood functions call for much smaller values of L Q for Mexico and Turkey, more in the region of 0.25, and also slower rates of P-mean reversion of λQ. For Korea, unconstrained estimates of L Q is close to .75. Therefore, set L Q = .75 for the rest of te study.
20. (Continued) Kappa is negative under Q measure and positive under P measure For the unconstrained case, LQ is very low for Mexico and Turkey, but LQ of Korea is close to the market convention
21. (Continued) Recall last slide where κPC > κPU, we expected larger differences between autocorrelation of constrained cases be higher But the result shows that the difference is negligible
22. Pricing Errors Assumption: Single risk factor underlies for λQ Motivation: co-movement PC1 explains a large variation of in spreads Potential role of a second risk factor (particularly for shorter maturities) Behaviors of bid-ask spreads. Is one-factor model enough? Among the various maturities, the one-factor model misprices the 1-year con tract most severely. Large institutes use 1 year CDS as their main vehicle to sovereign exposure.
23. The one-factor models match the correlations of levels of CDS spreads and slopes quite closely. The models do less well at matching the correlations among the first differences of these variables.
24. V. Priced Risks in Sovereign CDS Markets Take the ML estimates obtained in Section IV and construct two measures of fitted CDS spreads. To quantify the role of risk premiums regarding variation in λQ in percentage terms, compute: Watch out the peaks (run-up) of CRPt(M):
25. (continued) Observations -The adjustments to Mexico's risk premiums had the largest percentage effects on spreads -Early 2003: Korea’s credit card issues; SK -May 2004 : change in investors’ appetite for exposure to credit -March 2005: GM & Ford - 2006: large sell-off in EM equity market and unwinding carry trade in EM currencies; Turkey’s uncertainty of EU accession
26. (continued) A formal analysisof correlation between spreads and VIX, the spreads between 10-year U.S. BB industrial corporate bonds and 6-month U.S. T-bill, and the volatility in the own-currency options market Results: CDS premiums is influenced by spillovers of real economic growth in the U.S. to other countries Investors' appetites for credit exposure at a global level outweighs the reassessments of the fundamental strengths of these specific sovereign economies
27. Summary A single-factor model with λQ following a lognormal distribution captures the most variation of the term structure of CDS spreads. Premiums on sovereign CDS: Real economic growth of U.S. Change in investor’s appetites for credit exposure at a global level Looking ahead… a joint analysis of CDS spreads and other credit-sensitive derivative products. Case of Portugal CDS spreads
28. Source: Bloomberg
29. Sources Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads. Author(s): Jun Pan and Kenneth J. Singleton. Source: The Journal of Finance, Vol. 63, No. 5 (Oct., 2008), pp. 2345-2384Published by: Wiley for the American Finance Association Stable URL: http://www.jstor.org/stable/25094509. Accessed: 17/09/2013 14:50 Bloomberg Thank you