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Rating-Based CDS Curves

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<mark>Journal publication date</mark>31/01/2019
<mark>Journal</mark>European Journal of Finance
Issue number7
Volume25
Number of pages35
Pages (from-to)689-723
Publication StatusPublished
Early online date29/08/18
<mark>Original language</mark>English

Abstract

This paper explores the extent to which term structure of individual credit default swap (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 individual CDS deviations from the curve tend to diminish over time and CDS spreads converge towards the fitted curves. The likelihood of convergence increases with the absolute size of the deviation. The convergence is especially stable if CDS spreads are lower relative to the rating-based curve. Trading strategies exploiting the convergence generate an average return of 3.7% (5-day holding period) and 9% (20-day holding period).