Quantification of the restructuring event in the CDS price

1.5 Outlook for the restructuring event in the CDS contract

1.5.3 Quantification of the restructuring event in the CDS price

How do the different restructuring clauses affect the CDS market price?

Packer and Zhu(2005), in their article “Contractual terms and CDS pricing”, estimate the main differences between the prices of CDS contracts as a function of the restructuring event included in the CDS contracts, for the period from 11 February 2003 to 3 June 2004, using the Markit database. The main results of their study on the CDS quote, changing only the restructuring event for each issuer, are shown in Figure1.18.

Figure 1.18: CDS spread differences

Note: FR = CR (Full restructuring), NR=XR (No restructuring)

Source: Packer and Zhu(2005)

We have selected the year 2007, as a sample prior to the Big Bang Protocol to estimate the daily median of the ratio for every issuer of each restructuring clause with respect to the full restructuring clause, differentiat- ing the results by regions. For this analysis, we used the 5-year CDS contract because of its liquidity and we must not lose sight of the next equation of the restructuring event quote for the same issuer and currency. By definition, as the restructuring event is wide, we observe the following relation with respect to the restructuring event price for each CDS issuer for the same tenor contract:

CR>=MM>=MR>=XR2

Below we show the results obtained by regions. We start with the case of North America, one of the biggest CDS markets (Figure1.19). We observe that the daily median ratio is almost constant in the case of the MM ratio, in contrast to the MR and XR that show small jumps in the ratio time series.3The observed ratio values are similar to those of to the “Markit.com User Guide”, in February 2008 (Markit,2008), with ratio values of MM 96%, MR 95%, XR 91.5%. In Europe (Figure1.20), we observe that those ratios present a similar pattern to the North American case, but with less volatility. The Japanese case (Figure1.21) is special because the restructuring event is regulated in a total different way than the rest of the geographies; thus the XR quote is very different from the other observed values (around 78%). It is also worth mentioning that the MR and MM ratios converge clearly at the end of 2007.

Finally, we observe these ratios in the regions where we have fewer observations. It is interesting to note the instability of those ratios, reflecting a good proxy of the market’s illiquidity (Figures1.22and1.23). Therefore, it is easy to observe that in terms of restructuring event, these regions are more volatile than the markets in the developed regions, such as North America, Europe or Japan.

2CR: Full restructuring clause, MM: Modified modified restructuring clause, MR: Modified Restructuring and XR: No Restructuring clause. These clauses has been explained above.

Figure 1.19: North American restructuring clause ratio medians. Year 2007

Note: Y-axis: Daily Median Ratio Value.. X-axis: Year 2007. Green Line: Ratio (CR/CR). Red Line: Ratio (MM/CR). Blue Line: Ratio (MR/CR). Black Line: Ratio (XR/CR). The base denominator is CR, for this reason, the CR ratio is always 1.

Figure 1.20: European restructuring clause ratio medians. Year 2007

Figure 1.21: Japanese restructuring clause ratio medians. Year 2007

Figure 1.22: Latin American restructuring clause ratio medians. Year 2007

Figure 1.23: African restructuring clause ratio medians. Year 2007

As we mentioned before, after the Big Bang Protocol and with the great standardisation of the CDS contracts, we observe that the MM clause gained more importance in Europe, with more quotes than the CR clause. In North America, we observe the same trend with the XR clause increasing its quotes in contrast to the rest of restructuring clauses. In addition, it is important to highlight that the CDS prices from 2010 onwards are almost the same regardless of their restructuring clause (see Figures1.24,1.25,1.26). This can be motivated by two reasons:

1. By Big Bang Protocol itself, since it establishes a Credit Derivatives Determinations Committee (DC) to determine if credit and succession events occurred. Thus, the new protocol provides more transparency and standardisation to the default event, implying less differentiation in the CDS prices in terms of the restructuring clauses.

2. The CDS prices provided by Markit are composite prices; that is, they are the average prices for an issuer with a determined restructuring clause and currency. These prices go through a series of filters guar- anteeing the information quality. However, they are not “real” transaction prices. After consulting with Markit, they informed us that they have to provide different restructuring clause quotes on a daily basis, as financial entities still hold old contracts that need to be revalued. However, after the Big Ban Protocol, liquid markets to estimate the price of the different restructuring clauses for an issuer have disappeared. Therefore, we can conclude that the restructuring event was presented in the price of the CDS market prior to the Big Bang Protocol, as there is a theoretical basis. However, after the new protocol, the impact of the restructuring event on the price of the CDS market has been diluted and has lost importance by the increased standardisation of the CDS market.

Figure 1.24: European restructuring clause ratio medians. Year 2011

Note: Note: Y-axis: Daily Median Ratio Value. ( CR Base denominator). X-axis: Year 2007. Green Line: Ratio (CR/CR). Red Line: Ratio (MM/CR). Blue Line: Ratio (MR/CR). Black Line: Ratio (XR/CR).

Figure 1.25: North American restructuring clause ratio medians. Year 2011

Note: Note: Y-axis: Daily Median Ratio Value. ( CR Base denominator). X-axis: Year 2007. Green Line: Ratio (CR/CR). Red Line: Ratio (MM/CR). Blue Line: Ratio (MR/CR). Black Line: Ratio (XR/CR).

Figure 1.26: Asian restructuring clause ratio medians. Year 2011

Note: Note: Y-axis: Daily Median Ratio Value. ( CR Base denominator). X-axis: Year 2007. Green Line: Ratio (CR/CR). Red Line: Ratio (MM/CR). Blue Line: Ratio (MR/CR). Black Line: Ratio (XR/CR).

In document Risk premiumin the global creditMarkets: 2006-2012 (Page 53-59)