Financial Derivative Literature review Example | Topics and Well Written Essays - 750 words - 1

Financial Derivative - Literature review Example Experts state that market reactions are caused due to market reactions (Blanco, Brennan and Marsh, 2005). It is expected that default rates on bonds are possible due to market volatility, and as a result the cost of protection gets inflated on the bond values. The credit derivative markets during such a period had overreacted causing a contagion effect. The close relationship existing between the bond and CDS paves way towards the issue of estimating which market has the lead in the price discovery (Hull, Predescu and White, 2004). If the CDS market is leading, then it is expected that the bond market would adjust itself. In case, if the bond market is leading then the CDS market would simply follow the suit. Most researchers have opined that the impact of CDS upon the bond market is higher than that of the bond market upon the CDS. Innovations which occur in the CDS market are seen to spill over to the bond market. However, changes in the bond market impacts the CDS market in a much slower manner (Longstaff, Mithal and Neis, 2005). Nevertheless, during the crisis scenario it is seen that the influence of the CDS market upon the bond values is significantly slow and lees powerful as other market situations also impact the movement of the bond values. The relation between the two markets can be ascertained using statistical measures (Zhang, H. Zhou and H. Zhu, 2009). The main objective of the CDS derivative instrument is to cover the investor’s loss if the borrower fails to repay. Hence, both CDS and the bond depend upon the same determinants which are the probability of default on behalf of the borrower, the expected rate of recovery and the factors of risk aversion (Lipton and Sepp, 2009). Although the bond and the CDS market are interrelated deeply, their spreads are never the same. This can be understood through the statistical analysis of the spread. In a portfolio