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Essays in credit derivatives

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Title: Essays in credit derivatives
Author(s): Kitwiwattanachai, Chanatip
Director of Research: Almeida, Heitor
Doctoral Committee Chair(s): Pearson, Neil D.
Doctoral Committee Member(s): Almeida, Heitor; Pennacchi, George; Johnson, Timothy
Department / Program: Finance
Discipline: Finance
Degree Granting Institution: University of Illinois at Urbana-Champaign
Degree: Ph.D.
Genre: Dissertation
Subject(s): Asset Pricing Credit Derivatives Credit Default Swaps Risk Management Liquidity Correlation Recovery Rates
Abstract: This thesis consists of three essays that examine various problems in credit derivatives. In the first essay, we propose a novel method to extract asset correlations from credit derivatives. Default correlation is a concern especially after witnessing the financial crisis. To find default correlations, we would like to know asset correlations which are unobservable. We derive a model to infer asset correlations from Credit Default Swaps (CDS). We use a structural model approach with the first passage time as default. The resulting model is closed-form and extremely easy to compute. Using the data from 2004 to 2008, we find the average implied asset correlation from CDS to be over 0.4. The average equity correlation, which is usually used as a proxy for asset correlation, over the same period is 0.155. The result complies with the literature that there is another unobservable factor driving defaults among firms. The second essay examines the illiquidity of the CDS market. Researchers claim that CDS spreads reflect "purer" default risk than the bond spreads. We investigate whether the CDS market is really liquid. Since it is hard to define and measure liquidity precisely, we use an event study to answer the question. The event is when a CDS is included into the CDX index. This event changes the liquidity of CDS because they will be traded in the more liquid CDX market. If the CDS market is already liquid, we should observe no change in the level or correlation of CDS spreads. However, the spread levels do change, and the correlations between CDS and CDX index also change, to a lesser extent. The significant changes in the spread levels suggest that the CDS market is not perfectly liquid. The most likely channel for illiquidity is that order imbalance causes price impact depending on the direction of dealers' inventory. The third essay shows that stochastic recovery rates are priced ex ante in CDS and thus we can extract this information from CDS spreads. Recovery rates have been treated as a constant in the literature. However, recent empirical findings suggest that realized recovery rates are also stochastic and highly dependent on the industry condition. It is particularly hard to separate the effect of risk-neutral probability of default and risk-neutral recovery rates in CDS. We use the unique characteristic of ex post (physical) recovery rates to capture the ex ante (risk-neutral) recovery rates in CDS spreads. We find that the stochastic recovery rates affect the CDS spreads, ex ante. If the industry is in distress, the risk-neutral recovery rates are expected to be lower. We derive a simple first-passage-time structural model to capture the empirical findings. If the industry is in distress, the expected risk-neutral recovery rate will be lower by 20%. The model can be used to learn about expected recovery rates across business cycles from CDS data.
Issue Date: 2012-09-18
URI: http://hdl.handle.net/2142/34470
Rights Information: Copyright 2012 Chanatip Kitwiwattanachai
Date Available in IDEALS: 2012-09-18
Date Deposited: 2012-08
 

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