Title: Is credit default swap spread a leading indicator of bank default risk? Evidence of Indian banks during the COVID-19 pandemic

Authors: Vikas Srivastava

Addresses: Finance and Accounting Area Group, Indian Institute of Management Lucknow, IIM Road, Prabandh Nagar, Lucknow, 226013, India

Abstract: The paper investigates whether credit default swaps (CDSs) spread of Indian banks is a leading indicator for bank default risk. The paper uses Merton-type models to estimate theoretical CDS spread of the sample of Indian banks and then compares it to their balance sheet ratios. Though theoretically, higher CDS spreads indicate higher default risk, the paper finds that in times of shocks, like the present COVID-19 crisis, it becomes difficult to isolate the spread movements due to true default risk versus those based on panic and speculation. The paper then correlates equity premiums and CDS premiums and finds negative correlation. The equity market returns lead the CDS market returns in capturing default risk. As default risk is priced better in equity markets, it is preferable for institutional investors to trade default risk of Indian banks in the stock markets rather than the CDS markets.

Keywords: credit default swaps; CDSs; default risk; credit risk; Indian banks; COVID-19 pandemic; structural models of default; equity premiums; CDS premiums.

DOI: 10.1504/IJICBM.2023.129711

International Journal of Indian Culture and Business Management, 2023 Vol.28 No.3, pp.384 - 400

Received: 19 Jul 2021
Accepted: 28 Nov 2021
Published online: 21 Mar 2023 *

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