Financial derivatives and default dependence: a time-varying copula approach

Abstract

ABSTRACT The fast development of financial derivatives links financial institutions more closely. In this paper, we investigate the joint default dependence among financial institutions and its association with the recent development of financial derivatives. Two interesting findings emerge. First, time-varying default risk dependencies of financial institutions are found during our sample period. Second, the fast growth of derivatives markets contributes to the rising correlated default risk among financial institutions and further leads to an increase in systemic risk. We show that the default correlation spike coincides with the boom in the US credit derivatives market.