Relationships between Financial Sectors’ CDS Spreads and Other Gauges of Risk: Did the Great Recession Change Them? (original) (raw)
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The global crisis of 2007-2008 is the most severe crisis since the Great Depression in the financial markets. Starting with the subprime defaults in the United States, it quickly spills over into other markets leading to the collapses of many financial institutions, bail-outs of banks worldwide and downturns in asset prices. The aim of this thesis is to investigate the repercussions of this crisis on CDS and interbank market and provide empirical evidence on the changes in the pricing of CDS contracts and interbank deposits. Chapter 2 discusses the determinants of CDS spread changes on European contracts. The most remarkable finding of the study is that the relation between credit spreads and their determinants is regime dependant and depends on the sector of economic activity. Before the crisis the underlying credit risk in the overall CDS market is sufficient to explain credit risk. During the crisis investors have a differing view on the risk of financial and non--financial contr...
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Extending Longstaff's (2010) approach, this study uses the pre-, occurrence and persistentperiods of sub-prime crises in order to examine changes in global impulse responses, variance decompositions and contagion effects from the direct indices (i.e., ABX indices) of collateralised debt obligation (CDO), one kind of risky asset-backed securities (ABS), to the indices of credit default swaps (CDS). We then examine the similar approaches from CDS indices to associated bond indices. This paper is the first study to analyse the effects of shocks of financial crises on global bond markets through financial markets of risky ABS and CDS, simultaneously. These approaches are valuable because an investor buying a risky ABS tends to purchase a CDS to hedge the risks of the ABS, which then this CDS will transmit credit risks to capital markets. Our findings show significant impulse responses and contagion effects from lower-rated ABX index returns to associated CDS index returns, as opposed to higher-rated ABX index returns after a crisis occurs. During the outbreak of a crisis, a sharp increase in impulse responses from CDS index returns to bond index returns in emerging markets has been observed, as well as a larger rise in the variance ratio from CDS indices to Asian and Non-Asian emerging market bond indices, as opposed to developed market bond indices. Thus,
HOW DID CDS MARKETS IMPACT STOCK MARKETS? EVIDENCE FROM LATEST FINANCIAL CRISIS
It is well-documented that financial markets become more integrated during turmoil periods. In addition, the recent global financial crisis has led to an in depth analysis and discussion of the pros and cons of derivative instruments, particularly credit default swaps, which are considered as the best proxy for firm and sovereign default risk. The aim of this study is to explore if default risk, represented by CDS spreads, is embedded in stock returns. Our main assertion rests on the idea that if CDS spreads proxy default risk, then it should have informational content for stock markets and should have a significant impact in price formation process. The analysis is conducted by using CDS Regional Index spreads and MSCI Regional Index values in Europe, Pacific Region and Emerging Markets. The results indicate that changes in CDS Regional Index spreads significantly impact stock indices within the same region as well as cross-regionally.
Linkages between Financial Sector CDS Spreads and Macroeconomic Influence in a Nonlinear Setting
Research Papers in Economics, 2014
This paper investigates the asymmetric and nonlinear transmission of financial and energy prices to US five-year financial CDS sector index spreads for the banking, financial services and insurance sectors in the short-and long-run over the recent periods revolving around the global financial crisis. We employ the nonlinear ARDL (NARDL) model to account for the short-and long-run asymmetries in the sensitivity of those CDS sector index spreads to their determinants. Our findings suggest that there is evidence of short-and long-run nonlinearities and asymmetries in the adjustment process of the three CDS variables. There are also shortand long-run asymmetries in the influences of macroeconomic and financial variables on the CDS sector spreads. These findings are important for policymakers who deal with credit risks at the sector levels.JEL Codes: C32, F65, G01
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Systematic and Idiosyncratic Risks of Changes in CDS Spreads
2015
Using a sample of 356 U.S. non-financial firms from 2002 to 2011, we derive endogenous systematic credit risk and Credit Default Swap (CDS) illiquidity factors, and show that they dominate firm-specific and exogenous market factors as determinants of individual firms' CDS spreads. Our model performs well for cross-sectional predictions and can be used for estimating CDS spreads for firms that do not have traded CDSs. Our findings question Basel III's adoption of CDS-implied probability for counterparty risk management, as CDS spread is not a pure individual firm default risk measure devoid of market credit and illiquidity premia.
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The North American Journal of Economics and Finance, 2011
The objective is to examine the short-and long-run dynamics of US financial CDS index spreads at the sector level and explore their relationships with the stock market and the short-and long-run government securities, paying particular attention to the subperiod that begins with the 2007 Great Recession. We use daily time series for the three US five-year CDS index spreads for banking, financial services and insurance sectors, the S&P 500 index, the short-and long-term Treasury securities rates. Employing the Autoregressive Distributed Lag approach (ARDL), this study finds more long-run relationships between the five financial variables in Model II that includes the six-month T bill rate than Model I that includes the 10-year T bond rate. The long-run relationships have weakened in both models under the subperiod than the full period. Moreover, the short-run dynamics have changed under the subperiod but the changes are mixed. Implications are relevant for decision-makers who are interested in financial relationships at the sector level than at the firm level.
CDS Spreads: An Empirical Analysis of European Countries
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This thesis investigates how credit default risk as reflected in credit default swap (CDS) spread is transferred in the European countries. The first part observes the default risk transfer between the sovereign debt and the domestic financial institutions of the European countries during the European sovereign debt crisis. The previous literature indicates that a "two-way feedback" effect exists between the two sectors. In this part, the bailouts by the European Financial Stability Facility are used as breakpoints to examine the changes in the default risk transfer between the two sectors. The results suggest that the two-way feedback effect does not exist after the first Greek bailout. The shocks in the financial sector transmitting to the sovereign debts become either negative or insignificant in both the short and the long runs. Subsequent to the first Greek bailout, the private-to-public risk transfer no longer exerts significant impacts, regardless of later bailouts issued to the other countries. The second part further examines the structural regimes in the cointegration relationship of default risk between the two sectors. The empirical results indicate that the private-to-public risk transfer becomes stronger in the 'atypical' regimes, which covers the crisis periods. The approach of identifying changes in regime is robust, and the detected thresholds also confirm that it is reasonable using the EFSF bailout events as breakpoints. The final empirical chapter focuses on the crosscountry cointegration of sovereign default risk, and takes note of the role of investor sentiment in explaining the risk transfer. The findings show that investor sentiment is capable to predict regimes in the sovereign default risk in the short run. During crisis periods, the trench of the sovereign default risk is wider, but the elasticity is smaller, indicating more difficulties for the countries to close the gap of the default risk.
This paper analyzes counterparty exposures in the credit default swaps market and examines the impact of severe credit shocks on the demand for variation margin, which are the payments that counterparties make to offset price changes. We employ the Federal Reserve's Comprehensive Capital Analysis and Review (CCAR) shocks and estimate their impact on the value of CDS contracts and the variation margin owed. Large and sudden demands for variation margin may exceed a firm's ability to pay, leading some firms to delay or forego payments. These shortfalls can become amplified through the network of exposures. Of particular importance in cleared markets is the potential impact on the central counterparty clearing house. Although a central node according to conventional measures of network centrality, the CCP contributes less to contagion than do several peripheral firms that are large net sellers of CDS protection. During a credit shock these firms can suffer large shortfalls that lead to further shortfalls for their counterparties, amplifying the initial shock.