Counterparty Risk in Exchange Traded Notes (ETNs) : Theory and Evidence

In this paper we address the issue of counterparty credit risk in Exchange Traded Notes (ETNs). An ETN is a tracking product which is designed as an unsecured debt security. As such, it is subject to the issuers default risk. We describe a standard reduced-form pricing framework to gauge the theoretical effect credit risk should have on ETNs. We then derive firm specific real market credit risk measures using CDS data to construct model implied risk-adjusted ETN prices. Our results indicate that a substantial credit risk discount ought to be priced into ETNs. In sharp contrast, however, we find no evidence for credit risk pricing by market players based on real market ETN quotes. We allude to several behavioral biases that are consistent with our results