Credit default swap as an indicator of financial health of a company

Abstract

Traders and investors alike are constantly trying to maximize their returns and reduce their risks. While simple measures like liquidity, profitability, operating efficiency, leverage, bond yield, credit ratings etc. can be used as indicators of financial soundness, health or stability of companies, often, on their own, they are inadequate to predict insolvency or crisis because of the complex interactions and interdependencies between various elements in the financial system among themselves. As financial products became complex, a heightened level of uncertainty surrounded them and the various entities participating in the financial system began to advance their methodologies to measure sources of risk. Two major risks which were identified are market risk and credit risk. Market risk or systematic risk refers to the un-diversifiable risk arising from factors that affect the market in whole. An example is interest rate risk. Credit risk is the risk of default in payment by the borrower. This risk plays a key role in measuring the financial soundness of a firm and it is the key focus of our study. Credit derivatives were created to separate and transfer credit risk for parties who sought to hedge and diversify their risk exposure. These products enabled banks, investors and other participants in the financial markets to keep only their preferred risks and trade away others. The credit derivatives market began to grow fast in the late 1990’s. Various types of credit derivatives commonly traded are: 1. Credit Default Swaps. 2. Collateralized Debt Obligations. 3. Credit Spread Swaps. 4. Asset Backed Securities. 5. Mortgage Backed Securities. 6. Credit Spread Forwards etc.

Objective of the CCS: As a part of our CCS, we wish to study Indian credit default swaps (CDS) and access its performance as an indicator of financial soundness or health of a company by benchmarking its performance against Distance to Default, an aggregate state variable based on the ‘Kealhofer Merton Vasicek’ (KMV) model.