CDS Market to Measure Creditworthiness?

August 18, 2011 by · Leave a Comment
Filed under: The Ratings System 

William Mast, writing for Hemscott, explored the possibility of replacing rating agency evaluations with credit-default-swap (CDS) market pricing to predict creditworthiness. He suggested that CDS pricing was a more fluid, market-driven metric to gauge the health of an issuer.

He explains that one of the main criticisms of the rating agencies is that their view is limited to the historical analysis from a single point-in-time. A better model for measuring creditworthiness would be to use real-time information.

Mr. Mast writes, “Despite some technical pressures and, at times, lack of liquidity, the CDS market nevertheless provides the purest independent measure of how the market perceives the prospects of a given entity. This raises a question: If appropriately harnessed and interpreted, can the signals provided by the CDS market improve investors’ ability to anticipate changes in an issuer’s creditworthiness? There’s a body of research that suggests the answer is yes.”

He admits that the public’s concern over a perceived lack of transparency and regulation in the CDS markets needs to be addressed before it can be a viable evaluator. However, he cites among other research findings how, “In 2008, Fitch Solutions used CDS pricing to build market-implied ratings and concluded thatthere is a clear ability to forecast future rating actions by examining CDS premiums.”

The lack of broad and deep CDS markets across all asset classes are also a limiting factor in their use.

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