Determinants of Credit Default Swap Spread:

Evidence from the Japanese Credit Derivative Market

Agenda

Introduction Data Regression Analysis Robustness Check Conclusion

Introduction CDS Market Overview In the left-hand panel of this

Graph ,Remolona and Shim (2008) shows that Asia-Pacific names comprise almost a quarter of all those traded around the world

In right-hand panel, for a breakdown by economy within the region, this list shows a total of 921 names.

Japan has the greatest number of names in Asia-Pacific.

we consider Japan play an important role in the Asia-Pacific area.

Therefore, it is of interest to study credit spread determinants on Japan dataset,

The current study fills the gap in the literature by examining CDS spread in Japan market.

Introduction

Credit Spread ofEconomic Model Data

Regression Analysis

Level

Difference

Robustness Check

Conclusion

Credit Spread Dynamics

Structured Model

Credit Spread

Reduce-form Model

• Default Intensity

• Leverage level

• Volatility

• Risk-free Rate

Default Intensity process

Firm value process

• Default Prob.• Recovery Rate

CDS Spread

Structured Model

Black and Scholes(1973)

Merton(1974)

Collin-Dufresne, Goldstein, and Martin(2001)

Ericsson, Jacobs, and Oviedo(2005)

In this paper, we apply the structure model to the empirical examination of the Japanese CDS market, because it obviously describes the default mechanism and enables us to analyze the relationship between credit spread and financial and macroeconomic variables.

On the other hand, a reduced-form model assumes that a default process is unobservable and a latent factor known as default intensity determines the probability of default.

Brief summary of Credit Spread Drivers

Leverage level

Volatility

Risk-free Rate

Macroeconomic Factors

Credit Spread

++-?

•First, The higher leverage of a firm, the higher probability of default. •Second, increasing volatility will increase the default probability.•Third, the risk-free rate determines the risk-adjusted drift of firm value and thus an increase in the risk-free rate tends to decrease risk-adjusted default probabilities. •There is a negative relation between risk-free rate and credit spread.

Data Requirement of Dataset:

cds spread from Markit Group

180-day historical volatility ,leverage ratio from PACAP database.

Risk-Free Rate: Weekly data on 2-year Japan government bond yields are collected from Datastream database.

Observed firm: At least 252 observations of CDS Spread

106 Japanese firms from Markit Group database

Data Period : January 2001 to December 2004

Regression Analysis Dependent Variable

CDS Spread Level CDS Spread difference in a period

Explanatory Variables Leverage:

Historical Volatility: Sampling from 180 daily return of stock price in a shifting window

Risk-free Rate: weekly data on 2-year Japan Government Bond Yield Square of Risk-free Rate: To Capture potential nonlinear effect for Risk-free

Rate Slope of yield Curve :Difference between 2-year and 10-year Japan

Government Bond Yield which convey information on economic condition Market Return: Proxy for the overall business climate

DebtofValueBookEquityofValueMarketDebtofValueBook

We run univariate and multivariate regressions for the CDS spread and CDS Spread difference on explanatory variables based on the theory of the main determinants of credit spread.

We further separate the whole sample into sub-samples by various criteria. For example by credit rating, different sample period, and financial and non-financial industries.In general, our findings remain robust after controlling these various criteria.

Result•Table 1 Cross-sectional summary statistics•Table 2 Empirical results for the whole sample•Table 3 Results partitioned by credit rating•Table 4 Results partitioned by different sub-

sample periods (whole 2001-2004; separate into 2001-2002 &2003-2004 )

•Table 5 Results partitioned by financial and non-financial industry

From Table 3 to 5 , we reports Results partitioned by various criteria.

Table 1

Panel A indicates that there are firms with very high levels of CDS spreads.Panel B shows that financial leverage, firm specific volatility, and the risk-free rate, are more related to the CDS spread.

Table 2

From table 2 to table 6, we have the same table format, In Panel A is for level data and Panel B is for difference data. From table 2 to table 6, Regressions for level data has higher explanatory power over regressions based on difference data. First, we find that the coefficients on leverage are significant and positive. Second, the coefficients on historical volatility are also positively significant. Third, the results on the risk-free rate has a significant negative relation between CDS spread level and risk-free rate.

Table 3

For lower credit rating firms, leverage ,historical volatility and risk-free rate are more sensitive to CDS spread than higher credit rating firms..

Table 4

We find that, in general, the results for the sub-sample periods are very similar to each other and to the whole sample period results. In general, our results in Table 4 suggest that the theoretical explanatory variables remain robust to explain the CDS spread for different time periods in Japan.

Table 5

The theoretical variables, such as leverage; historical volatility, and risk-free rate show similar results as the whole sample. However, the results for financial industry show different pattern, compared to non-financial industry, which may be due to unique characteristics of financial firms. In general, our findings remain robust after controlling financial and non-financial industry firms.

Robustness Check

A robustness check using an alternative approach. Following Collin-Dufresne, Goldstein, and Martin (2001) and Ericsson, Jacobs, and Oviedo (2005), we estimate the coefficients by first running the time-series regressions for each firm Calculate the cross-sectional mean of the estimated coefficients.

Table 6

The results are similar to those in the previous section.

ConclusionThis study investigates the determinants of CDS spread for the Japanese market and contributes the literature. Effects of level in leverage and implied volatility on CDS

spread are positively significant. A negative relation between risk-free rate and CDS

spread. Theoretical determinants perform well in explaining cross-

sectional variation in the level of CDS spread. Limited explanatory power on the difference 0f CDS

spread. Findings are consistent with the theory with statistical

significance.