Implications for Risk Management and Regulation: A Study of Long-Term Dependence in the Credit Default Swap (CDS) Indices Market

Abstract

In this study, the authors shed light upon the nature and degree of market risk inherent in CDS instruments, and consequently offer suggestions to the regulators with regard to the level of regulatory reserves that ought to be mandated to avert extreme disasters or meltdowns in the future. If the underlying behavioral patterns of the CDS markets mimic a coin toss, then successful change in spread levels are independent of one another. Consequently, the level of regulatory reserves can be much less, as opposed to a scenario wherein the underlying behavioral dynamics of CDS markets are characterized by fat-tailed distribution and long-term dependence. For this exercise, the authors chose the two most liquid CDS indices, namely CDX.NA.IG of North America and iTraxx.Europe of Europe. Mandelbrot’s rescaled range estimation technique was employed on iTraxx and CDX datasets to test for long-term dependence. Despite their non-normality, the findings revealed that the long-term dependence co-efficient of iTraxx and CDX was more in line with less-risky traditional companies. Consequently, the authors believe that regulators should realize that not all CDS markets are toxic in nature. In fact, Investment-grade CDS indices such as CDX.NA.IG and iTraxx.Europe appear to be less-riskier than high-tech stocks. The study’s findings reflect the need for regulators to acknowledge prevalence of certain benign CDS markets within the overall CDS landscape that is currently labeled as highly toxic for a variety of reasons. Finally, the authors also subjected the American and European CDS datasets to Lo’s modified rescaled range estimation technique, which appropriately accounts for short-term dependence, non-normal innovations, and conditional heteroscedasticity. The results pertaining to Lo’s technique revealed prevalence of short-term dependence. This revelation offers huge potential for future research in CDS markets, from a technical analysts’ perspective.