Measuring credit risk: The relation between CDS Spreads, the modified Merton model and credit ratings

University essay from Lunds universitet/Nationalekonomiska institutionen

Abstract: Prior articles and reports have named Credit Default Swap (CDS) spreads as a plausible indicator of default risk. In this report, the authors present a significant correlation between CDS spreads and two other more acknowledged methods of measuring default risk probabilities; the modified Merton model and credit ratings from the rating institute Moody’s. The tests are implemented by Spearman’s rank correlation with data obtained between the years 2008 to 2011. The sample is based on 30 firms in Europe and America, respectively, and is chosen after the number of outstanding CDS contracts in November 2012. In order to get as accurate results as possible, the selection of firms are separated into financial and non-financial sectors: five financial and 25 non-financial firms, respectively for each continent. The CDS spreads are obtained from 5-year maturity contracts and are taken from Thomson Reuters DataStream. The variables needed to calculate the modified Merton are obtained from the same source as well as from comprehensive Excel files provided by professor Aswath Damodaran at NY University.

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