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The relationship between distance-to-default and CDS spreads as measures of default risk for European banks

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Ristolainen K.

Journal of Banking and Financial Economics

2016

issue 1(5)

121-143

CDS spreads are often seen as the ’leading’ market based, default risk measure. There is no popular alternative to CDS spreads except perhaps for the distance-to-default (D2D) measure based on Merton (1974), which comes very close to it. In this paper, we investigate the correlation and short-term dynamics between these two measures for large European banks with a data panel spanning from 1/2006 to 12/2013. The analysis makes use of conventional Granger causality test statistics for individual banks and for the whole panel data. As regards the results, we found that the lead-lag relationship between these highly related variables varies over time, over different banks, and over economic regimes. The lead of D2D is signifi cantly stronger for banks that are smaller relative to the other banks in the sample, banks in problem countries (PIIGS), after global financial crises, during market turmoil, and for banks with poor credit quality indicated by a high CDS spread. These results and the fact that D2D can be calculated for every bank quoted on the stock exchange suggests that D2D is a promising alternative to the CDS spread in default risk assessment of banks.

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1 Journal of Banking and Financial Economics

1 Ristolainen K.

1 2016

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The relationship between distance-to-default and CDS spreads as measures of default risk for European banks