Effect of counterparty risk on CDS spreads during crisis.

Abstract

We study the effect of counterparty risk on the credit default swap (CDS) spread. For our study, we use the 2008 subprime mortgage crisis period and the collapse of the Lehman Brothers which is a big counterparty during the crisis as a proxy for the effect of counterparty risk on the CDS spread. We hypothesize that credit event involving a counterparty will enhance the effect of crisis on the CDS spread. To prove our hypothesis, we have used data of CDS holdings by bond funds in 2008 from the NQ-form and also day to day changes in CDS spread from Markit database. This phenomenon is further tested by looking at the industry factor; financial and non-financial industry, the depth of the market, which involves the number of dealers in the CDS market and also the credit rating of the reference entity. We found that the effect of crisis on CDS spread is magnified when Lehman Brothers is the counterparty, which shows that the credit event involving counterparty does affect the CDS spread. Also, this effect is larger for financial industry, market with lesser dealers and investment grade bonds with lower credit ratings. The robustness check that we have conducted proves that our results are consistent across different currencies and maturities.