Pricing credit default swaps with observable covariates

H. Doshi, J. Ericsson, K. Jacobs, S. Turnbull

Research output: Contribution to journalArticleScientificpeer-review

Abstract

Observable covariates are useful for predicting default, but several studies question their value for explaining credit spreads. We introduce a discrete-time no-arbitrage model with observable covariates, which allows for a closed-form solution for the value of credit default swaps (CDS). The default intensity is a quadratic function of the covariates, specified such that it is always positive. The model yields economically plausible results in terms of fit, the economic impact of the covariates, and the prices of risk. Risk premiums are large and account for a smaller percentage of spreads for firms with lower credit quality. Macroeconomic and firm-specific information can explain most of the variation in CDS spreads over time and across firms, even with a parsimonious specification. These findings resolve the existing disconnect in the literature regarding the value of observable covariates for credit risk pricing and default prediction.
Original languageEnglish
Pages (from-to)2049-2094
JournalThe Review of Financial Studies
Volume26
Issue number8
Publication statusPublished - 2013

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Credit default swaps
Pricing
Covariates
No-arbitrage
Macroeconomics
Default prediction
Closed-form solution
Economic impact
Credit spreads
Credit default swap (CDS) spreads
Risk premium
Default intensity
Price of risk
Discrete-time
Credit
Credit risk

Cite this

Doshi, H., Ericsson, J., Jacobs, K., & Turnbull, S. (2013). Pricing credit default swaps with observable covariates. The Review of Financial Studies, 26(8), 2049-2094.
Doshi, H. ; Ericsson, J. ; Jacobs, K. ; Turnbull, S. / Pricing credit default swaps with observable covariates. In: The Review of Financial Studies. 2013 ; Vol. 26, No. 8. pp. 2049-2094.
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Doshi, H, Ericsson, J, Jacobs, K & Turnbull, S 2013, 'Pricing credit default swaps with observable covariates', The Review of Financial Studies, vol. 26, no. 8, pp. 2049-2094.

Pricing credit default swaps with observable covariates. / Doshi, H.; Ericsson, J.; Jacobs, K.; Turnbull, S.

In: The Review of Financial Studies, Vol. 26, No. 8, 2013, p. 2049-2094.

Research output: Contribution to journalArticleScientificpeer-review

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Doshi H, Ericsson J, Jacobs K, Turnbull S. Pricing credit default swaps with observable covariates. The Review of Financial Studies. 2013;26(8):2049-2094.