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Credit risk signals in CDS market vs agency ratings

Michael Jacobs Jr (Financial Advisory, Risk Models, Methodologies & Analytics, Accenture Consulting, New York, New York, USA)
Ahmet K. Karagozoglu (Department of Finance, Zarb School of Business, Hofstra University, Hempstead, New York, USA)
Dina Naples Layish (Department of Finance, School of Management, Binghamton University, Binghamton, New York, USA)

Journal of Risk Finance

ISSN: 1526-5943

Publication date: 21 March 2016

Abstract

Purpose

This research aims to model the relationship between the credit risk signals in the credit default swap (CDS) market and agency credit ratings, and determines the factors that help explain the variation in such signals.

Design/methodology/approach

A comprehensive analysis of the differences in the relative credit risk assessments of CDS-based risk signals and agency ratings is provided. It is shown that the divergence between credit risk signals in the CDS market and agency ratings is explained by factors which the rating agencies may consider differently than credit market participants.

Findings

The results suggest that agency credit ratings of relative riskiness of a reference entity do not always correspond with assessments by CDS spreads, as the price of risk is a function of additional macro and micro factors that can be explained using statistical analysis.

Originality/value

This research is unique in modeling the relationship between the credit risk assessments of the CDS market and the agency ratings, which to the best of the authors' knowledge has not been analyzed before in terms of their agreement and the level of discrepancy between them. This model can be used by investors in debt instruments that are not explicitly CDSs or which have illiquid CDS contracts, to replicate market-based, point-in-time credit risk signals. Based on both market-based and firm-specific factors in this model, the results can be used to augment through-the-cycle credit risk assessments, analyze issues surrounding the pricing of CDSs and examine the policies of credit rating agencies.

Keywords

Acknowledgements

The views expressed herein are those of the authors and do not necessarily represent a position taken neither by Accenture Consulting, nor of any affiliated firms. Karagozoglu acknowledges Zarb School of Business Summer Research Grant, which partially supported this article.

Citation

Jacobs Jr, M., Karagozoglu, A. and Layish, D. (2016), "Credit risk signals in CDS market vs agency ratings", Journal of Risk Finance, Vol. 17 No. 2, pp. 194-217. https://doi.org/10.1108/JRF-07-2015-0070

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Publisher

:

Emerald Group Publishing Limited

Copyright © 2016, Emerald Group Publishing Limited

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