Credit Default Swaps - Essays on Model and Market Efficiency

Essay 1 tests the ability of a commercial structural credit default swap pricing model to predict market spreads. Consistent with several previous studies testing other models, we find our model unable to price credit risk precisely and observe an illiquidity premium reflecting a credit risk component which should be incorporated into future pricing models. We also identify macroeconomic and stock market factors that help explain movements in CDS spreads beyond the levels suggested by the model.Essay 2 looks at bid and ask spreads to find evidence of quote shading where dealers manipulate their quotes in order to attract sell orders. This is something not yet studied in CDS literature and we draw on studies on the foreign exchange markets for theoretical support. We find that dealers are more likely to indulge in quote shading when firm risk increases but not close to weekends or holidays. We also look at price discovery with and without quote shading but our results are inconclusive. Using the put-call ratio as a risk level indicator, we find that price discovery in the CDS market decreases as firm risk increases.Essay 3 looks at the quality of the CDS market in the backdrop of the recent financial crisis. Previous studies have found that CDS markets lead price discovery only in the case of high risk firms and this paper tests if price discovery dynamics have shifted in favour of the CDS market since overall firm risk levels have increased. Using Granger-causality tests, we compare stock and CDS markets before and since the crisis and finds that despite an overall increase in risk levels, the stock market continues to lead the CDS market in all risk categories. We also test the CDS market for mis-reaction using Variance Ratios and find that while there was evidence of over-reaction before the crisis, CDS market is under-reacting since the crisis.