Statistical modelling of relationship between CDS spread and bond yield

Abstract

Credit derivatives were introduced in India recently which was demanded by the market participants for quite some time. Though the government has introduced Credit Default Swaps (CDS) with some restriction, It will take some time before the market for credit derivatives develops. India financial markets need to develop new capabilities in order to take full advantages of this financial innovation. There are accounting, valuation, and risk management complexities involved with credit derivatives. In future, we may see some relaxation in the norms of credit derivatives, If the results are in accordance with the expectations. It has been reported by various researchers that CDS spread leads the bond yield. Till now few Indian companies have issued bonds in overseas markets and CDS spread for those companies also exists. The relationship has been established for 3 out of 4 companies where CDS spread leads the bond yields. One of the most important findings is the difference in lag time for bonds of developing countries as compared to developed countries. Bonds from developing countries are less liquid, and the opportunity of arbitrage has reduced as compared to bonds of developed countries where the market activity is high, and arbitrage opportunity may exist.