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

Abstract

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