For lower-rated issuers, default risk is a major factor linking an issuer’s bond and equity prices. As default risk increases, equity prices fall as the residual claimants of the firm, the shareholders, face the possibility that the firm may go bankrupt. Similarly, bond prices fall because debtholders face the possibility of not being paid in full. For higher-rated issuers, default risk is not a major driving factor of bond and equity prices because the current value of the firm’s assets largely exceed its debt, This appendix formalizes these arguments in Merton’s corporate debt model (Merton, 1974) and explains why it holds true for both corporate and sovereign issuers.
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Longstaff, Francis, Sanjay Mithal, and Eric Neiss, 2003, “The Credit Default Swap Market: Is Credit Protection Priced Correctly” (unpublished; Los Angeles: University of California).
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We would like to thank Todd Groome, Donald Mathieson, Michele Nicoletta, and David Xu for their comments and suggestions. We remain responsible for any errors or omissions.
Underlying assets may be bank loans or commercial bonds. Or it could be other financial obligations on which the cash flows and/or credit event for credit derivatives are based.
Credit risk is a risk that the counterparties to transactions will fail to make obligated payments. Credit risk is sometimes called default risk. Market risk refers to movements in interest rates, exchange rates, stock prices, or commodity prices.
It should be noted here that in the United States restructuring is accepted as a credit event while it is not accepted in Europe. Therefore, sometimes, the U.S. contract may not be substitutable for European contract.
In September 2003, banks sold US$1.3 trillion of gr/oss credit protection though they were net buyers of protection in the amount of US$229 billion. Insurance companies sold protection in a net amount of US$303 billion (FitchRatings, 2003).
Although a large number of contracts are written on 5-year maturity, investment banks also write CDS contracts on the notional amounts and maturities specified by their clients. For corporate and financial institutions, however, trading activity is greatest for five-year contracts.
The main assumptions are: first, the risky bond and the risk-free bond are par-floating rate securities. Second, there are no transaction costs, and tax effects are negligible. Third, the payment of the CDS spread stops if a credit event occurs. Finally, protection buyers are paid on the next coupon date following the occurrence of the credit event.
The interested reader should refer to the original citations, Baillie and others (2002), and Lehman (2002). See Blanco, Brennan, and Marsh (2003) for an application to CDS and bond spreads at the corporate level,
The negative coefficients further suggest that the equity market in these countries are prone to price bubbles.