THE LIAISON BETWEEN CORPORATE BOND SPREADS AND CREDIT DEFAULT SWAP SPREADS Evidence from Japanese credit risk markets 2006-2015.

Abstract

In the last 20 years the fascination in credit markets has turned to the subject of credit derivatives of which the most popular have been credit default swaps. The derivatives introduced in the early 90’s have been subject of intense scientific debate, especially in the 2000s. These derivatives and their deregulation have been considered as one of the primary cause of the debt crisis formation. The explanatory power of credit default swaps in credit risk pricing, hedging and benchmarking corporate bond markets has been found in several recent studies.

Majority of the prior relative studies have focused on U.S and European credit risk market. For this thesis, the main purpose was to study the liaison between corporate bond spreads and credit default swaps in Japanese credit risk market. The underlying assumption for the relation is that both bond spreads and CDS spreads should price the credit risk equally. This means that each of the spreads should entail similar information about the reference entity and the markets.

The Markit iTraxx Japan Series 17 index is selected as a data base utilized in this study. From the total 50 entities, 17 entities were eliminated and 33 entities were used for the data analyses. The research questions and the hypotheses were tested with co-integration -, Gonzalo & Granger -, Granger causality - and Vector error correction test. Also regression analyses were included to see how different macro- and idiosyncratic factors affect the spreads. The full data period 2006-2015 is divided into two different periods, before the crisis 1.1.2006-1.8.2008 and during financial crisis period between the 1.8.2008- 31.12.2014.

The study consist of 7 different hypotheses. The results of the study suggest that there is an equilibrium between the bond markets and the CDS markets in longer term. Secondly swap rates are used as reference risk free bond yields by market practitioners, rather that government yields. Thirdly CDS spreads were found to be superior in price discovery over bond spreads, while idiosyncratic factors affect CDS more than bond spreads. With macroeconomic factors no significance affect for CDS spreads and bond spreads is found. Finally with selected factors no conclusions were able to be drawn from the counterparty risk affect over CDS spreads and bond spreads.