How do sovereign risk, equity and foreign exchange derivatives markets interact?

Abstract

To examine the propagation of shocks across markets, this paper examines the dynamic connections between three distinct markets: the credit default swaps (CDS), equities, and cross-currency basis swaps (CCBS) of four major individual economies: the Eurozone, the UK, Australia, and Japan. We use CDS spreads, CCBS spreads, and stock market returns to capture sovereign credit risk, dollar funding pressure, and stock market performance, respectively. Our results show that a feedback mechanism connects these markets. Higher CDS spreads induce wider CCBS spreads and declines in stock market returns; positive shocks to CCBS spreads lessen CDS spreads and enhance stock market returns; and positive shocks to the stock market lead to lower CDS spreads and tighter CCBS spreads. These findings are supported by Granger causality analysis and are robust across subperiods and empirical specifications. Underpinning the feedback mechanism is the role of CDS as an indicator of potential default on obligations.