Explaining Credit Default Swap Index Spreads - A Study of the iTraxx Index

Sammanfattning: In this paper we investigate the relationship between the European iTraxx spreads and the theoretical determinants suggested by the Merton model during the period from June 2004 to September 2006. The Merton model suggests that leverage, volatility and the risk-free rate should influence credit spreads. We use the returns on relevant equity indices, their historical volatility, the European volatility index VSTOXX and the German government 10-year yield as proxies for the respective variables. As predicted by the Merton model, we find the changes in the iTraxx spreads to be negatively related to changes in the equity index returns and the risk-free rate as well as positively related to changes in the volatility on the market. Furthermore, we are able to confirm the validity of the Merton model through a robustness test, including other variables to the regression. Nevertheless, the Merton model provides only limited explanatory power. By including a liquidity measure as well as adding the lag of the iTraxx spreads we are able to increase the explanatory power of the model substantially.