The Number of State Variables for CDS Pricing

Biao Guo, Qian Han and Doojin Ryu

No 2013-10-14, Working Papers from Wang Yanan Institute for Studies in Economics (WISE), Xiamen University

Abstract: This study investigates the number of state variables needed for CDS pricing by conducting a principal component analysis using CDS data for the 2006-2009 period. Two state variables, approximated by the first two components, are found sufficient for pricing CDS spreads. The first component corresponds to a market level factor and can explain over 97% of the variation in the data, resulting in a 20.04 bps root mean square error (RMSE). The second component corresponds to a liquidity level factor and can explain an additional 1.7% of the variation, helping to reduce the RMSE to 5.29 bps. A rigorous bootstrap test, together with two robustness tests, on the model performance improvement corroborates our conclusions. The study sheds light on CDS pricing and provides support for the most recent findings that liquidity risk is priced in CDS spreads.

Keywords: Credit Default Swap; Liquidity; Local Linear Regression; Principal Component (search for similar items in EconPapers)
JEL-codes: C13 C14 G13 G14 (search for similar items in EconPapers)
Date: 2013-10-14
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