A value at risk analysis of credit default swaps

We study the risk of holding credit default swaps (CDS) in the trading book. In particular, wecompare the Value at Risk (VaR) of a CDS position to the VaR for investing in the respectivefirm’s equity. Our sample consists of CDS – stock price pairs for 86 actively traded firms overthe period from March 2003 to October 2006. We find that the VaR for a stock is usually farlarger than the VaR for a position in the same firm’s CDS. However, the distance betweenCDS VaR and equity VaR is markedly smaller for firms with high credit risk. The distance alsodeclines for longer holding periods. We also observe a positive correlation between CDS andequity VaR.[...]