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Essays on credit risk

Jeong Seog Song, 2008
Faculty Advisor: Michael Adler
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In the first chapter, I test whether credit risk for Emerging Market Sovereigns is priced equally in the credit default swap (CDS) and bond markets. The parity relationship between CDS premiums and bond yield spreads, that was tested and largely confirmed in the literature, is mostly rejected. Prices below par can result in positive basis, i.e. CDS premiums that are greater than bond yield spreads and vice versa. To adjust for the non-par price, we construct the bond yield spreads implied by the term structure of CDS premiums for various maturities. I am able to restore the parity relation and confirm the equivalence of credit risk pricing in the CDS and bond markets for many countries that have bonds with non-par prices and time varying credit quality. I detect non-parity even after the adjustment mainly with countries in Latin America where the bases are beyond the bid ask spreads of the market. I also find that repo rate of bonds decreases around the credit quality deterioration, which helps the basis remain positive.

In the second chapter, I develop various frameworks for the separation of loss given default and default probability from various credit instruments. They include spot and forward credit default swaps, digital default swaps and defaultable bonds. Cross-sectional no-arbitrage restriction between different securities allows the pure measure of default probability and loss given default not contaminated by the other. Using spot and forward CDS premium data of 10 emerging market sovereigns, I find that 75% level of loss given default prevails in the sovereign CDS markets across countries over time. Positive correlation between loss given default and default probability is only found in Brazil and Venezuela during the period of political turmoil in each country. This result is puzzling considering diverse fundamentals across countries and time variation of the marginal rate of substitution. Loss given default below (above) the 75% generates negative (positive) pricing errors in forward CDS and the magnitude of them is economically significant.


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