Credit Risk and Credit Default Previous Research

19 to the protection seller for secure their bond investment from the potential of default by the reference entity. If the reference entity facing the default during the life of the contract, the protection seller will pays the par to the protection buyers. Meanwhile, if the reference entity is not facing the default during the life of the contact, so that, the protection buyers will lose their premium or spread. Unlike the traditional insurance, should not to have any reference assets to buy the CDS. It generally called naked basis. In the CDS spreads payment are known the terms of settlement payment. According to Carboni 2011, the settlement payment is made by the seller according to the contract settlement option. In credit derivatives, there are two options contract of the settlement, they are cash settlement and physical settlement. In the physical settlement, when a credit event occurs, the buyer delivers the reference asset to the seller, in return for which the seller pays the face value par value of the delivered asset to the buyer. The contract may specify a number of alternative assets called deliverable obligations that the buyer can deliver when the default is occur. On the other hand, in the cash settlement option the contract specifies a predetermined payout value when a credit event occurs. Generally, the protection seller pays the buyer the difference between the nominal amount of the default swap and the final market value of the reference asset, determined by the dealer banks. This last value can be viewed as the recovery value of the asset. 20

1. The purposes of CDS

According to the types of reference entity, the CDS contracts can be categorized into two groups. The first one is corporate CDS and the other one is sovereign CDS. The International Monetary Fund 2013 is mentioned the objectives of Sovereign Credit Default Swap SCDS: a. Hedging : The owners of sovereign bond buy SCDS to protect themselves against losses arising from a default or other credit event affecting the value of the underlying debt. b. Speculating : SCDS contracts can be used to buy or sell protection on a naked basis, the buyer of SCDS does not have any reference assets to express a negative or positive opinion about the credit outlook of the issuer of the underlying bonds. c. Basis trading : SCDS are used get a profit from differences between SCDS and the underlying bond obligations price by taking offsetting positions in the two “basis trading”. This strategy is based on the principle that CDS can be used to replicate the cash flows of underlying obligations.

E. Macroeconomic Variables

Macroeconomic is the branch of economic that examines the economic behavior of aggregates income, employment, output in the national scale. Case, et. al, 2009:32. There are a lot of macroeconomic variables that can be used to measure the condition of a country. In this study, the author 21 emphasize on five macroeconomic variables to figure out the effect of macroeconomic variables toward CDS spreads in Asia and Europe. The following explanation will describe the macroeconomic variables used by the author:

1. GDP Growth Rate

Gross Domestic Product GDP is the total market value of all final goods and services produced within a given period by factors of production located within a country. Case, et. al, 2009:129. Recent levels of country’s GDP may be used to measure recent economic growth Madura, 2010:480. According to Frank and Bernanke 2009:439, there are two ways to measure GDP, they are: a. Real GDP : a measure of GDP in which the quantities produced are valued at the price in a base year rather than at current pricees; real GDP measures the actual physical volume of production. b. Nominal GDP : a measure of GDP in which the quantities produced are valued at current-year prices; nominal GDP measures the current dollar value of production. The GDP growth rate measures how fast the economy is growing. It does this by comparing one quarter of the countrys economic output Gross Domestic Product to the last. The GDP growth rate is driven by 22 the four components of GDP. The most important driver of GDP growth is personal consumption, which includes retail sales. GDP growth is also driven by business investment, which includes construction and inventory levels. Government spending is another driver of growth, and is sometimes necessary to jumpstart the economy after a recession. Last, but not least, are exports and imports. Exports drive growth, but increases in imports have a negative impact Amadeo, 2014 Annual percentage growth rate of GDP at market prices based on constant local currency. GDP is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources www.worldbank.org , 2014a. The research relates to the relationship between GDP growth and Credit Default Swap spreads had conducted by Brandrof and Homberlg 2010 indicate that CDS spreads decrease in GDP growth rate.

2. Inflation

Inflation is an increase in the price level, but not all price increases constitutes to inflation. When prices of some goods are rising and the others are falling, these are relative price changes, while inflation occurs when there is an increase on overall price level Case, et. al, 2009:154. 23 According to www.worldbank.org 2014b, inflation can be determined by either Consumer Price Index or GDP deflator. Inflation as measured by the Consumer Price Index reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services. Meanwhile the inflation as measured by the annual growth rate of the GDP deflator shows the rate of price change in the economy as a whole. This research is using the inflation measured by the Consumer Price Index data. The research relates to the relationship between inflation and the Credit Default Swap spreads had conducted by Sand 2012, the result indicates that the inflation variable is significantly affect the CDS spreads.

3. Unemployment

In the United States, defining and measuring the unemployment is the responsibility of Bearu of Labor Statistics BLS. According to Frank and Bernanke 2009:449, a person is unemployed if he or she did not work during the preceding week but made some effort to find a work, in the past four weeks. To find the unemployment rate, the first step that should have to calculated is the size of labor force. Labor force is defined as the total number of employed and unemployed people in the economy. People who are in the age of 16 or older who are in the school or disable is not counted as unemployed, thus, they are not affect the unemployment rate. The unemployment rate is defined as the number of unemployed people 24 divided by the labor force. In general, a high rate of unemployment rate indicates that the economy of a country is performing poorly. Unemployment rate is the ratio of the number of people employed to the total number of of people in the labor force Case, et. al, 2009:148. Unemployment refers to the share of the labor force that is without work but available for and seeking for a job www.worldbank.org , 2014c . The research relates to the relationship between unemployment and Credit Default Swap spreads CDS had conducted by Brandrof and Holmberg 2010, the result shows that the CDS spreads increase in unemployment.

4. ImportGDP

Imports of goods and services represent the value of all goods and other market services received from the rest of the world. They include the value of merchandise, freight, insurance, transport, travel, royalties, license fees, and other services, such as communication, construction, financial, information, business, personal, and government services. They exclude compensation of employees and investment income formerly called factor services and transfer payments www.worldbank.org , 2014d. 25 The relationship between importGDP and CDS spreads had conducted by Sand 2012, the result shows that the CDS spreads is increase along with the increasing on the importGDP variable.

5. Current Account Balance

The balance of payments consist of the current account and capital account. In this study I focus on the current account. Current account represents a summary of the flow of funds between one specified country and all other countries due to the purchases of goods or services, or the provision of income on financial assets Madura, 2010:27. Madura 2010:27-28 describes the main components of the current account, they are payments for: a. Merchandise goods and services : merchandise exports and imports represent tangible assets, while the service exports and imports represent tourism and other services, such as insurance. b. Factor income payments : income interest and dividend payments received by investors on foreign investment in financial assets. c. Transfer payments : represented by aid and grants. According to Case,et. al, 2009:402, the balance of payments is the record of a country’s transactions in goods, services, and assets with the other countries, also the record of a country’s sources supply and uses demand of foreign exchange. Meanwile the current account balance is 26 net exports of goods + net exports on services + net invetment income + net transfer payments. The relationship between current account balance and Credit Default Swap spreads had conducted by Sand 2012, the result shows that the higher current account balance led to the lower CDS spreads.

F. Previous Research

Research regarding the effect of macroeconomic variables toward Credit Default Swap spread had conducted by some of the researchers. The result can be elaborated as follows: 1. Alexander and Andreas β008 had conducted a research titled “Regime dependent determinants of credit default swap spreads”. In their research Alexander used daily quotes of iTraxx Europe CDS indices and restrict the analysis to indices with a maturity of 5 years. The data period starts from June 2004 and ends in June 2007. The applied method for analyze are Linear regression and Markov switching regression. Using Interest rate, stock return and implied volatility variables, the result shows that All of the variables that is interest rate, stock return, and implied volatility are significant toward the CDS spreads. 2. Greatrex 2008 had conducted a research relates to the credit default swap market’s deteminants. In her research, Greatrex uses 333 firms as the sample and employ 6 variables to be investigated. She uses Stock retuns, leverage ratio, volatility, the rating based index, treasury rate, slope of yield curve and 27 investigates the impact of these variables toward CDS spreads. The data for conducting this research is monthly, from January 2001 until March 2006. The result shows that a rating-based CDS index is the best predictor of CDS spread changes. Leverage and volatility, are also key determinants, as these two variables can explain almost half of the explained variation in monthly CDS spread changes. 3. Baum and Wan 2010 were conducted a research regarding the macroeconomic uncertainty and credit default swap spreads on individual firms. To measures the macroeconomic variables, Baum and Wan use variance of the GDP growth rate, the index of industrial production and the returns on the SP 500 Composite Index and the other variables such as market value, leverage ratio, return on equity, and dividend payout ratio. For conducting this research, they used monthly data from January 2001 to December 2006, and 5 years CDS spreads from 527 firms. The result shows that the macroeconomic uncertainty is an important determinant of CDS spreads. 4. Tang and Yan 2010 had conduct a research regarding Market conditions, default risk and credit spreads. This research is specified on the impact of the interaction between market and default risk on corporate credit spreads. They use large scale firm-level CDS data that allow them to investigate the relative explanatory power of macroeconomic conditions and firm characteristics and the effect of their interactions. They limit their research on the U.S. corporate 28 bond issuers denominated in US dollars with the period of outstanding CDS contracts between June 1997 and November 2006. They employ GDP growth rate, GDP growth volatility, jump risk and investor sentiment to measure the market conditions; and coefficient of variation in quarterly operating cash flow, firm growth, cash flow beta, leverage, implied volatility and jump as the slope of option implied volatility curve to measure the firm characteristics. The result shows that average credit spreads decrease in GDP growth rate, but increase in GDP growth volatility and jump risk in the equity market. At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads generally rise with cash flow volatility and beta. Implied volatility is the most significant determinant of default risk among firm-level characteristics. 5. Liu and Morley 2011 was conducted a research regarding Sovereign Credit Default Swaps and the Macroeconomic. On their research, Liu and Morley use domestic interest rate and the exchange rate to represent the macroeconomic variables. The sample that used by the author is the U.S. and France. These two countries have been selected due to their importance in the international financial system and because they represent different approaches to exchange rates as well. The data used from conducting this research is daily from March 19 th 2008 to September 30 th 2010 for the U.S. and from August 16 th 2005 to September 30 th 2010 for the France. The result shows that the 29 exchange rates has the most significant variable, while the domestic interest rate has a slightly effect on SCDS spreads. Table 2.2 will be showing the overview of previous research that had conducted by some of the researchers. Table 2.2 Overview Previous Research No Resercher Analysis model Dependent Variables Independent Variables Result Journal Number 1 Alexander and Andreas 2008 Linear regression and Markov switching regression CDS spreads Interest rate, stock return, implied volatility All of the variables that is interest rate, stock return, and implied volatility are significant toward the CDS spreads. Journal of Banking Finance 32 2008 1008 –1021 2 Greatrex 2008 Multivariat e regression model CDS spreads Stock retuns, leverage ratio, volatility, the rating based index, treasury rate, slope of yield curve. A rating-based CDS index that accounts for both credit risk and overall market conditions is the best predictor of CDS spread changes. Leverage and volatility, are also key determinants, as these two variables can Fordham University Discussion Paper No: 2008-05, March 2008 30 No Researcher Analysis Model Dependent Variable Independent Variable Result explain almost half of the explained variation in monthly CDS spread changes. Journal Number 3 Baum and Wan 2010 OLS and fixed-effect regression CDS spread Macroecono mic uncertainty computed by the conditional variance of the GDP growth rate, the index of industrial production and the returns on the SP 500 Composite Index.; market value; leverage ratio; ROE; Dividend payout ratio. Macroeconomic uncertainty has significant explanatory power over and above that of traditional macroeconomic factors such as the risk-free rate and the Treasury term spread. Applied Financial Economics Taylor Francis Journal vol. 20 15 page: 1163-1171 4 Tang and Yan 2010 Regression Corporate credit spread Firm CDS data; GDP growth rate; GDP growth volatility; Jump risk; Investor sentiment; CVCF; Firms At the market level, investor sentiment is the most important determinant of credit spreads. At the firm level, credit spreads Journal of Banking and Finance 34, 743-753, 2010 31 No Researcher Analysis Model Dependent Variable Independent Variable growth, Cash flow beta, Leverage, Implied volatility and Jump Result generally rise with cash flow volatility and beta. Implied volatility is the most significant determinant of default risk among firm- level characteristics. Journal Number 5 Liu and Morley 2011 VaR Sovereign CDS spread Domestic interest rates and Exchange rates Exchange rate has the most important effect on sovereign CDS markets. Bath Economic Research Papers no 031, 2011. Source: Author

G. Theoretical Framework

Theoretical framework is a conceptual model of how one theorizes or makes a logical sense of the relationship among the several factors that have been indentified as important to the problem. The theoretical framework discusses the interrelationship among the variables that are deemed to be integral of the situation being investigated. Sekaran, 2003:87. Figure 2.2 will show the theoretical framework of this research: 32 Figure 2.2 Theoretical Framework Sovereign Bond Market Macroeconomic Variables GDP growth X 1 Inflation X 2 Unemployment X 3 ImportGDP X 4 Current account balance X 5 Sovereign Credit Default Swap Spread Y CCL ADF Classic Assumption Test PLS FEM REM Hypothesis Test F Test t Test Conclusion and Suggestion PP Chow test Stationary Test Normality Heteroscedasticity Multicollinearity Panel Data Regression Hausman test Autocorrelation 33 The theoretical framework shows that the relationship between the dependent and independent variables is causative relationship or cause and effect. According to Malhotra 2004:85 the purposes of causal research are: 1. To understand which variables that are the cause independent variables and which variables that is the effect dependent variables of a phenomenon. 2. To determine the nature of relationship between the causal variables and the effect to be predicted. Based on the illustration of theoretical framework that have served in figure 2.2, it can be read that the independent variables in this research are: GDP growth rate X 1 , inflation X 2 , unemployment X 3 , importGDP X 4 , current account balance X 5 and the dependent variable that is Credit Default Swap spreads Y.

H. Hypothesis

The hypothesis for this research concerned on whether there is an effect on dependent variable toward independent variable or there is no effect on dependent variable toward independent variable. Hypothesis of this research can be stated as follows: 1. H = There are no effect between macroeconomic variables represented by GDP growth rate, inflation, unemployment, importGDP, current 34 account balance toward Credit Default Swap spreads in Asia and Europe. H 1 = There are an effect between macroeconomic variables represented by GDP growth rate, inflation, unemployment, importGDP, current account balance toward Credit Default Swap spreads in Asia and Europe. 2. H = GDP growth rate does not affect the Credit Default Swap spreads in Asia and Europe. H 1 = GDP growth rate does affect the Credit Default Swap spreads in Asia and Europe. 3. H = Inflation does not affect the Credit Default Swap spreads in Asia and Europe. H 1 = Inflation does affect the Credit Default Swap spreads in Asia and Europe. 4. H = Unemployment does not affect the Credit Default Swap spreads in Asia and Europe. H 1 = Unemployment does affect the Credit Default Swap spreads in Asia and Europe. 5. H = ImportGDP does not affect the Credit Default Swap spreads in Asia and Europe. H 1 = ImportGDP does affect the Credit Default Swap spreads in Asia and Europe. 35 6. H = Current account balance does not affect the Credit Default Swap spreads in Asia and Europe. H 1 = Current account balance does affect the Credit Default Swap spreads in Asia and Europe.