Systematic and Idiosyncratic Default Risk in Synthetic Credit Markets

Peter Feldhütter, Mads Stenbo Nielsen

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Abstract

We present a new estimation approach that allows us to extract from spreads in synthetic credit markets the contribution of systematic and idiosyncratic default risk to total default risk. Using an extensive dataset of 90,600 credit default swap and collateralized debt obligation (CDO) tranche spreads on the North American Investment Grade CDX index, we conduct an empirical analysis of an intensity-based model for correlated defaults. Our results show that systematic default risk is an explosive process with low volatility, while idiosyncratic default risk is more volatile but less explosive. Also, we find that the model is able to capture both the level and time series dynamics of CDO tranche spreads.
Original languageEnglish
JournalJournal of Financial Econometrics
Volume10
Issue number2
Pages (from-to)292-324
Number of pages33
ISSN1479-8409
DOIs
Publication statusPublished - 2012

Keywords

  • CDO Pricing
  • Correlated Defaults
  • Credit Risk
  • Intensity Based Model

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