0
$\begingroup$

If the var-covar matrix for equities takes the return on equity prices, what should the var-covar matrix for credit derivatives (like a CDS) take?

Should it be the probability of default, since that usually determines the prices of the credit derivatives?

I'm not sure on what would be the equivalent of equity return for credit derivatives and would appreciate any help on this.

Improve this question
$\endgroup$

1 Answer 1

Reset to default
1
$\begingroup$

As a general principle, you should try to calculate statistics from market observables. Credit spreads are observable. If CDS trades, then you can see CDS quotes. If debt trades or is marked to market, then you can figure out how much they yield in excess of credit risk-fgree rates. But probabilities of default (physical or risk-neutral) are not observable.

Improve this answer
$\endgroup$
2
  • $\begingroup$ So, if I use excess of bond yield over the risk free rate to compute the covar matrix, would that be fine? $\endgroup$
    – coffee-raid
    Mar 4, 2022 at 13:00
  • 1
    $\begingroup$ Yes. In a simplest case, use one spread per ossuer. Or have term structure of the spread (may or may not be useful). If an issuer's debt in multiple currencies, you can have spreads by currencies (not much difference). You can split the spread into country of risk + rating + idiosyncratic issuer. $\endgroup$
    – Dimitri Vulis
    Mar 4, 2022 at 16:56

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge that you have read and understand our privacy policy and code of conduct.

Not the answer you're looking for? Browse other questions tagged or ask your own question.