Credit Spreads, Default Corelations and Cdo Tranching: New Evidence from CDS Quotes
31 Pages Posted: 7 Aug 2008
Abstract
In a risk-neutral environment, credit spread has been regarded as a function of two variables, i.e., default probability and recovery rate. Once the recovery rate is determined, a spread can be employed to calculate implied default rate of a specific credit name. Most importantly, default correlation is not considered as a factor to determine the credit spread. However, recent development of credit basket market, e.g., Collateralized Debt Obligation (CDO) and credit tranching techniques have some impacts on financial markets. A new market called correlation trading has forced the credit spread to approach a new equilibrium based on default correlation. This research investigates the relationship between credit spread (of individual credit name) and default correlation (of a credit basket). CDS market data is employed to empirically test the correlation effect. The empirical results provide some evidence that correlation between individual name and market index influences mean spread on CDS.
Keywords: Credit Risk, CDS, Single Tranche CDO, Default Correlation
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