SIFR Research Report Series,
Institute for Financial Research

Abstract: Using a new dataset of bid and offer quotes for credit default swaps, we investigate the relationship between theoretical determinants of default risk and actual market premia using linear regression. These theoretical determinants are firm leverage, volatility and the riskless interest rate. We find that estimated coefficients for these variables are consistent with theory and that the estimates are highly significant both statistically and economically. The explanatory power of the theoretical variables for levels of default swap premia is approximately 60%. The explanatory power for the differences in the premia is approximately 23%. Volatility and leverage by themselves also have substantial explanatory power for credit default swap premia. A principal component analysis of the residuals and the premia shows that there is only weak evidence for a residual common factor and also suggests that the theoretical variables explain a significant amount of the variation in the data. We therefore conclude that leverage, volatility and the riskfree rate are important determinants of credit default swap premia, as predicted by theory.

Keywords: Credit default swap; Credit risk; Structural model; Leverage; Volatility

JEL-codes: G12

49 pages, September 15, 2004

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