Merton's Model Explaining CDS Spreads - a panel data study of OMX Stockholm traded firms

Abstract: Credit risk arises in almost all financial activities. One way to hedge and trade risk is to use Credit Default Swaps that act like an insurance against credit events. The value of the CDS is related to the probability of the reference entity defaulting. In this paper we aimed to determine how well the variables implied by the Merton model explain the CDS spread. A panel data study of 16 companies belonging to the OMX Stockholm equity index shows that the variables have limited explanatory power. An increasing stock return is narrowing the credit default swap spread, but the time dummies account for most of the variation.