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Credit Default Swap Prices as Risk Indicators of Large German Banks

by Klaus Düllmann of Deutsche Bundesbank, and
Agnieszka Sosinska of the Universität Frankfurt

June 2005

Abstract: This paper explores empirically the usefulness of credit default swap (CDS) prices as market indicators. The sample of reference entities consists of large, internationally active German banks and the observation period covers three years.

By analysing the explanatory power of three risk sources, idiosyncratic credit risk, systematic credit risk, and liquidity risk, we gain important insights for modelling the dynamics of CDS spreads. The impact of systematic risk, for example, has two components, one related to the overall state of the economy and the other to a banking-sector specific component. Contrary to previous research for corporate bonds we find that CDS premia of German banks rise with an increasing risk-free interest rate, which may be explained by its impact on term transformation risk.

We compare default probabilities, inferred from a tractable reduced form model for CDS spreads, with expected default frequencies from the Moody's KMV model. The results provide empirical support to the hypothesis that structural models based on equity market prices may be less informative than reduced-form models of CDS spreads, especially for banks with major investment banking activities, because the leverage looses explanatory power.

Although the CDS market appears to have matured in the observation period, in certain periods premiums for liquidity risk can substantially increase which limits their value as market indicators. We conclude that equity prices and CDS premia should be considered together to fully exploit the information content of both market indicators and to mitigate their respective drawbacks.

JEL Classification: G12, G21, G13, C13.

Keywords: credit default swaps, credit risk, market indicators, reduced-form models.

Published in: Financial Markets and Portfolio Management, Vol. 21, No. 3, (September 2007), pp. 269-292.

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