Rating Based CDS Curves

Abstract

In this paper, we explore the extent to which term structure of individual CDS spreads can be explained by the firm’s rating. Using the Nelson-Siegel model, we construct, for each day, CDS curves from a cross section of CDS spreads for each rating class. We find that the fitted CDS curves contain meaningful information in the sense that 76% of their time-series variations can be explained by the typical credit and liquidity factors that are known to drive CDS spreads. The residuals, on the other hand, contain mostly transient liquidity information. Moreover, deviations from the curve tend to disappear and CDS spreads converge towards the fitted curves over time; the larger is the deviation, the more likely is the convergence. Trading strategies exploiting the convergence of deviations could potentially generate an average return of 3.6% (5 days holding period) and 9% (20 days holding period). Our findings suggest that our CDS curves contain the core credit and liquidity information, which could be used to price other CDSs of the same rating class. This is important in credit risk management where the CDS spreads of a wide spectrum of ratings and term structure are needed for evaluating counterparty risk.