The empirical relationship between the spreads of Credit Default Swaps and Bonds

Scientific Essay from the year 2010 in the subject Business economics - Investment and Finance, , language: English, abstract: Warren Buffet, the world's richest man, once said that derivatives are financial "weaponsof mass destruction." a term popularized by George W. Bush to describe nuclear arms.Indeed financial derivatives have a far greater impact on the market than their underlyingdue to their leverage effect. And the most popular and important credit derivativesnowadays are credit default swaps with a current notional value of over 60 trillion USdollars according to ISDA 1 (International Swaps and Derivatives Association) and 58trillion US dollars according to BIS 2 (Bank for international settlement) respectively. Thatis more than the whole world's gross domestic product in the same year! 3This paper examines the empirical relationship of CDS premium and credit spread bytesting on their theoretical equivalence derived by Duffie (1999). It begins with anoverview of CDS followed by the theoretical framework. The analysis starts withexplanation of testing methods and description of data. After confirming the existence ofthe basis spread, this paper goes on to analyse the interactions of CDS spread and Bondspread using econometrics methods like Cointegration and Granger Causality tests. Alsoexamined is the leadership of price discovery process between CDS market and traditionalbond market.