The Delivery Option in Credit Default Swaps
by Rainer Jankowitsch of Vienna University of Economics and Business Administration,
October 18, 2006
Abstract: Under standard assumptions the reduced-form credit risk model is not capable of accurately pricing the two fundamental credit risk instruments - bonds and credit default swaps (CDS) - simultaneously. Using a data set of euro-denominated corporate bonds and CDS our paper quantifies this mispricing by calibrating such a model to the bond data and subsequently using it to price CDS, resulting in model CDS spreads up to 50% lower on average than observed in the market. An extended model is presented which includes the delivery option implicit in CDS contracts emerging since a basket of bonds is deliverable in default. By using a constant recovery rate standard models assume equal recoveries for all bonds and hence zero value for the delivery option. Contradicting this common assumption, case studies of Chapter 11 filings presented in the paper show that corporate bonds do not trade at equal levels following default. Our extension models the implied expected recovery rate of the cheapest-to-deliver bond and, applied to the data, it largely eliminates the mispricing. The calibrated recovery values lie between 8% and 47% for different obligors, exhibiting strong variation among rating classes and industries. A cross-sectional analysis reveals that the implied recovery parameter depends on proxies for the delivery option, primarily the number of available bonds and the bond pricing errors. No evidence is found for the influence of liquidity proxies.
Keywords: credit risk, default, corporate bond, credit default swap, reduced-form model, recovery rate, delivery option.
Published in: Journal of Banking & Finance, Vol. 32, No. 7, (July 2008), pp. 1269-1285.