How Important is a Non-Default Factor for CDS Valuation?

Abstract

Unlike previous research based on structural or reduced-form models, we investigate the importance of a non-default factor for credit default swap (CDS) valuation by conducting non-parametric local linear regression analyses using corporate CDS data from 2002 to 2011. We find that a model with an additional non-default factor significantly outperforms a model with only a default factor, both in-sample and out-of-sample, particularly for low credit rating CDS spreads. This improvement is robust to both credit rating and maturity. Our findings support the idea that non-default risk is priced in CDS spreads and help explain CDS valuation.