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| Trading Strategies in the CDS Market by Andreas Tindlund of the Norwegian University of Science and Technology (NTNU) August 16, 2006 Abstract: I construct a logical financial model for ranking CDS contracts in order of expensiveness based on their spread. The model is based on the hypothesis that forward default probabilities from Moody's KMV calculated by the Vasicek-Kealhofer (VK) model contains forward predictive power not captured by the market. A simple filter rule divides contracts into two portfolios of the most overpriced and underpriced CDS contracts on a monthly basis for the period of 2001-2005. I find that the portfolios outperform the market at a statistically significant level. The study is a natural extension of earlier work where similar approaches have been used for the bond market and where significant outperformance has also been found. However, contrary to earlier work, I also find that the level of outperformance has been significantly reduced for the period of mid-2003 to 2005 than for the period of 2001 to mid-2003. The results in this paper therefore indicate that the forward predictive power of the VK-model has weakened, possibly explained by the market correcting an inefficiency. Keywords: Credit default swaps, Credit spreads, CDS, Trading strategies, Moody's KMV, KMV. Books Referenced in this Paper: (what is this?)
Download paper (3,140K PDF) 31 pages Related reading: On the Equivalence of the KMV and Maximum Likelihood Methods for Structural Credit Risk Models
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