A Value at Risk Analysis of Credit Default Swaps

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A Value at Risk Analysis of Credit Default Swaps

by Burkhart Raunig of the Austrian Central Bank, and
Martin Scheicher of the European Central Bank

December 2007

Abstract: We study the risk of holding credit default swaps (CDS) in the trading book. In particular, we compare the Value at Risk (VaR) of a CDS position to the VaR for investing in the respective firm's equity. Our sample consists of CDS – stock price pairs for 86 actively traded firms over the period from March 2003 to October 2006. We find that the VaR for a stock is usually far larger than the VaR for a position in the same firm's CDS. However, the distance between CDS VaR and equity VaR is markedly smaller for firms with high credit risk. The distance also declines for longer holding periods. We also observe a positive correlation between CDS and equity VaR.

JEL Classification: E43, G12, G13.

Keywords: Credit default swap, Value at Risk, Capital structure arbitrage.

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