A Structural Analysis of the Default Swap Market – Part II (Relative Value)

Lisa Goldberg, Rajnish Kamat and Jason Kremer

Volume 7, Number 2, Second Quarter 2009

We evaluate several long/short strategies for managing a portfolio of default swaps. The strategies are based on a ranking of credits by residuals, which are the differences between market spreads and spreads generated by the iSpread structural model. Investment grade portfolios for the United States and Europe earned an average of 70 basis points for each long dollar notional between January 2004 and December 2006. Noninvestment grade portfolios earned 321 basis points averaged over the same regions and time period. Transaction cost estimates based on scenario analysis ranged from 19 to 27 basis points for investment grade and 26 to 54 basis points for noninvestment grade portfolios. Strategies that aim to mitigate transaction cost by holding trades with little profit showed mixed results.