ISDA highlights a selection of research papers on derivatives and risk management.

Single-Name and Index CDS Dynamics during the Market Stress of 2022

Office of the Chief Economist Commodity Futures Trading Commission
By John Coughlan, Madison Lau and Alexei Orlov

The paper examines the dynamics of the credit default swaps (CDS) market during the COVID-related market disruption in 2020. The analysis is based on the US Commodity Futures Trading Commission’s Part 45 data on CDS transactions and positions.

The paper shows there was a significant preference for standard index CDS over non-standard index and single-name CDS. Standard index CDS are defined as major indices that fall under the clearing mandate, including CDX North American Investment Grade and High Yield and iTraxx Europe and Crossover.

Gross notional of standard index CDS contracts nearly doubled by the middle of March 2020, while single-name CDS and non-standard indices remained relatively unchanged at the pre-COVID level. Investment-grade indices in the US and Europe accounted for a major share of traded notional during the period.

The increase in standard index CDS trading was driven by swap dealers that more than doubled their starting position. Hedge funds and asset managers accounted for most client trading activity.

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Lending Relationships and Currency Hedging

Banco Central do Brasil Working Paper Series
By Sérgio Leão, Rafael Schiozer, Raquel F. Oliveira and Gustavo Araujo

This paper analyzes the impact of firms’ lending relationships on their access to over-the-counter (OTC) foreign exchange (FX) derivatives. The analysis uses contract-level data on OTC FX derivatives traded between banks and non-financial firms in Brazil and data on bank loans.

The study finds that firms are more likely to trade FX derivatives with one of their lenders than a non-lending bank. The likelihood of trading a derivative with a lender increases when the bank is the firm’s main lender. Both findings are stronger for smaller firms.

Using data on non-deliverable forward contacts that exchange Brazilian real for US dollars, the analysis shows that the firm’s main lender offers significantly better pricing. This result is more pronounced for smaller firms. However, lending relationships don’t affect other contractual terms. The study doesn’t find any evidence that firms trade different notional amounts or different maturities with lending banks.

The authors argue that both firms and their lending banks benefit when they trade FX OTC derivatives. Lending banks have an advantage over non-lending banks due to information that has been previously acquired from loan contacts. Additionally, firms’ usage of derivatives for hedging may help reduce banks’ loan portfolio risk.

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It’s Not Time to Make a Change: Sovereign Fragility and the Corporate Credit Risk

European Central Bank Working Paper Series
By Fabio Fornari and Andrea Zaghini

This paper examines the impact of sovereign ratings downgrades on corporate credit risk. In particular, the study analyzes the effect of downgrades by the three main credit rating agencies on euro-area corporate credit default swap (CDS) spreads.

The analysis finds that sovereign downgrades lead to significant increases in corporate CDS spreads. Corporations that can’t diversify their revenues over different countries, are closely linked with domestic demand and have a rating assessment close to the sovereign rating are more likely to suffer from the sovereign downgrade.

The study also examines the possibility of international contagion. The authors find that the sovereign downgrades of core economies had a stronger effect on other countries’ corporate credit risk than on the core economies themselves. The downgrades of Greece, Ireland, Italy, Portugal and Spain had a strong effect on corporate sector credit risk of all these countries.

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