Frailty risk in the cross-section of credit default swap spreads


Understanding the correlation structure of corporate defaults is of predominant importance for the stability of our economy. Recently, it became apparent that unobserved factors, common to all corporates, drive correlated defaults. This exposure to an unobserved factor is known as frailty risk. Since Credit default swaps (CDS) are derivatives to hedge against defaults, they are closely linked to an entity’s probability of default (PD) and the potentially priced frailty risk.

In a first step, we improve analyses of CDS spreads in the recent literature by using timely PD estimates instead of using Credit Ratings which only change infrequently. This allows for analyzing CDS spreads with more precision. Still, preliminary work shows that known factors (macroeconomic variables as well as entity specific variables) leave a high portion of variation unexplained. In a second step, therefore, a new estimation technique is developed to decompose unexplained CDS spreads into a latent common factor – the frailty risk factor – and idiosyncratic parts as well as their respective loadings. A key question is whether frailty risk is consistently priced in the cross section of CDS spreads.

The results of this project are of great importance for both academics and practitioners alike. From an academic perspective, understanding the pricing of CDS spreads is one way to assess market efficiency and thereby to judge the efficiency of the economy’s resource allocation mechanism. Practitioners face new accounting rules (IFRS 9) which require a timely PD estimation throughout the lifetime of the entity’s life cycle. Quantifying frailty risk is an important step for yielding such timely PD estimates. In particular, this project has great potential to acquire third party funding from the DFG and the banking industry.

Project duration: 21 months