Systematic and Idiosyncratic Default Risk in Synthetic Credit Markets

Peter Feldhütter and Mads Stenbo Nielsen

Journal of Financial Econometrics, 2012, vol. 10, issue 2, 292-324

Abstract: We present a new estimation approach that allows us to extract from spreads in synthetic credit markets the contribution of systematic and idiosyncratic default risk to total default risk. Using an extensive dataset of 90,600 credit default swap and collateralized debt obligation (CDO) tranche spreads on the North American Investment Grade CDX index, we conduct an empirical analysis of an intensity-based model for correlated defaults. Our results show that systematic default risk is an explosive process with low volatility, while idiosyncratic default risk is more volatile but less explosive. Also, we find that the model is able to capture both the level and time series dynamics of CDO tranche spreads. Copyright The Author 2012. Published by Oxford University Press. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Date: 2012
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