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International Monetary Fund, 2002a, Global Financial Stability Report, World Economic and Financial Surveys (Washington, March).
International Monetary Fund, 2002b, Global Financial Stability Report, World Economic and Financial Surveys (Washington, December).
Marsh, Ian, 2002, “What Central Banks Can Learn about Default Risk from Credit Markets,” in Market Functioning and Central Bank Policy, BIS Papers No. 12 (Basel: Bank for International Settlements).
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Rieu, Anne-Marie, 2001, “Analysing Information in Risky Bonds and Credit Derivatives: An Application to the Telecom Industry” (unpublished; London: Bank of England).
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Special thanks are due to Eric Beinstein for kindly sharing his dataset. Comments and discussions with Yoon-Sook Kim, Janet Kong, Donald Mathieson, Jorge Roldos, Manmohan Singh, and Amadou Sy helped to improve this article. Errors and omissions remain my own responsibility.
See Tavakoli (1998) for descriptions and examples of other credit derivatives contracts such as total return swaps, credit spread options, and credit-linked notes, among others.
British Bankers’ Association, 2002, Credit Derivatives Report 2001/2002.
See IMF (2002b), Chapter IV, for a comprehensive discussion of derivatives markets in emerging markets, including credit derivatives.
The 1999 ISDA Credit Derivatives Definitions include the following six types of credit event: (1) bankruptcy; (2) failure to pay; (3) restructuring; (4) repudiation/moratorium (for a sovereign entity); (5) obligation default; and (6) obligation acceleration.
See Marsh (2002) for an in-depth discussion of the default swap basis. Rieu (2001) conducts an empirical investigation of what factors underlie basis changes for France Telecom both in time and along the term structure. Rule (2001) and IMF (2002a) analyze the financial stability implications of credit derivatives markets.
This option ameliorates the pricing abnormalities that may arise when the number of CDS contracts outstanding exceeds the number of the reference bond in the contract.
A widening of spreads does not necessarily reflect a fundamental deterioration of the credit quality of the bond issuer. Investment policy constraints requiring institutional investors to hold only investment-grade issues may cause speculators to build up substantial short positions on an investment-grade reference issue, either through the cash market or the CDS market, in the expectation that the ensuing widening of spreads and decline in equity prices would prompt a rating downgrade to non-investment grade. Once the reference issue is downgraded, the forced sell-off allows short-sellers to cover their positions profitably.
Ongoing work using dynamic term structure models addresses these shortcomings.