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Exploring mispricing in the term structure of CDS spreads

Jarrow, R.
; 
Li, H.
; 
Ye, Xiaoxia
; 
Hu, M.
Publication Date
2019-02
End of Embargo
Supervisor
Keywords
Credit default swaps, Mispricing, Statistical arbitrage, Affine models, Market-neutral strategy, Hedge funds
Rights
(c) The Author(s) 2018. Published by Oxford University Press on behalf of the European Finance Association. All rights reserved. For permissions, please email: journals.permissions@oup.com
Peer-Reviewed
Yes
Open Access status
openAccess
Accepted for publication
14/03/2018
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Department
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Management and Law Publications
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Abstract
Based on a reduced-form model of credit risk, we explore mispricing in the CDS spreads of North American companies and its economic content. Specifically, we develop a trading strategy using the model to trade out of sample market-neutral portfolios across the term structure of CDS contracts. Our empirical results show that the trading strategy exhibits abnormally large returns, confirming the existence and persistence of a mispricing. The aggregate returns of the trading strategy are positively related to the square of market-wide credit and liquidity risks, indicating that the mispricing is more pronounced when the market is more volatile. When implemented on the Markit data, the strategy shows significant economic value even after controlling for realistic transaction costs.
URI
http://hdl.handle.net/10454/15730
Version
Accepted manuscript
Citation
Jarrow R, Li H, Ye X et al (2018) Exploring mispricing in the term structure of CDS spreads. Review of Finance. 23(1): 161-198.
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Link to published version
Link to Version of Record
https://doi.org/10.1093/rof/rfy014
Type
Article
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Notes