Essays on Credit Default Swaps

This dissertation focuses on the investigation of the credit derivative market. It consists of an analysis of credit default swaps (CDS) based on corporate bonds and a study of the indexed CDS—the ABX.HE index, which references subprime residential mortgage-backed securities as the underlying reference entities. The first chapter examines the CDS pricing model and explores the key determinants of the price error measured by the absolute value of the CDS-bond basis. Specifically, I assess the efficiency of different risk-free rate proxies--Treasury Yields, EFFR/OIS rates and SOFR/OIS rates--in the CDS pricing model. The result indicates that Treasury yields overperform the other two proxies in improving pricing accuracy. To estimate the theoretical CDS spread, I compare two pricing models: one based on conditional default probabilities and another based on unconditional default probabilities. The findings suggest that the unconditional default probabilities approach provides CDS estimates closer to the market-quoted value for bonds rated B and above. This study also covers the period of the COVID-19 pandemic, revealing that pricing accuracy decays during economic downturns. Moreover, even though categorical factors such as credit ratings and sector contribute to price discrepancies, the idiosyncratic factors play a dominant role in driving the price error. Chapter two analyzes the ABX.HE index from early 2006 to mid-2012 to explore the subprime residential mortgage-backed securities market. In the beginning, the introduction of mortgage-backed security (MBS), collateralized debt obligation (CDO) and credit default swap (CDS) provides the context for the creation of the ABX.HE index. After outlining the criteria and mechanics of the index, the event study method is employed to examine the influence of default risk and market liquidity-related events on the ABX.HE index price. The results show that news about alleviating default risk does not improve the index price. Nonetheless, senior securities are still expected to respond to their rating downgrades and possible downgrades from credit agencies. Moreover, rating downgrades and possible downgrades in the insurance sector tend to influence securities with median quality. In the market liquidity improvement sector, monetary policies are more likely to improve subordinated securities and above. Events concerning fiscal policies passed by the House improve more subindices than other fiscal policy categories. Finally, the most interesting observation is that the abnormal index return is more likely to happen on a day with multiple liquidity events.