A Structural Analysis of the Default Swap Market, Part 1 (Calibration)

Lisa R. Goldberg, Rajnish Kamat and Vijay Poduri

Volume 6, Number 3, Third Quarter 2008

We analyze the default swap market with the two factor I2 structural model, which is driven by firm value and firm leverage. As we show empirically, the de- fault swap market incorporates these risks differentially over time, by region, by industry, and by coarse quality. This leads us to pool firms with similar character- istics into calibration groups whose parameters are used to align model and market sensitivities to the risk factors. We include equity factor returns to account for contagion and momentum effects for industries or credits that have suffered recent downturns. The close alignment of our model spreads with the market enables us to extract systematic effects reflected in the dynamics of average levels of model inputs and outputs, and discern relative value among credits by analyzing model errors. Applications of our model include assessment of relative value, pricing of illiquid names, cross market hedging and monitoring credit portfolios. A rich-cheap portfolio construction strategy based on our model shows consistent profits in most calibration groups between January 2004 and May 2006.