Abstract
This study complements the current literature, providing a thorough investigation of the lead–lag connection between stock indices and sovereign credit default swap (CDS) returns for 14 European countries and the US over the period 2004–2016. We use a rolling VAR framework that enables us to analyse the connection process over time covering both crisis and non-crisis periods. In addition, we analyse the relationship between stock market volatility and CDS returns. We find that the connection between the credit and equity markets does exist and that it is time variable and seems to be related to financial crises. We also observe that stock market returns anticipate sovereign CDS returns, and sovereign CDSs anticipate the conditional volatility of equity returns, closing a connectedness circle between markets. Contribution percentages in terms of returns are more intense in the US than in Europe and the opposite result is found with respect to volatilities. Within Europe, a greater impact in Eurozone countries compared to non-Eurozone countries is observed. Finally, an additional analysis is also carried out for the financial sector, obtaining results largely consistent with those found using sovereign data.
Highlights
After the Lehman Brothers default in September 2008, international financial markets experienced devastating distortions, highlighting the importance of the study of risk management, especially credit risk, for both academics and professionals. This interest has been revived in recent years in the context of the European debt crisis, where credit spreads rose to unprecedented levels, to a greater extent in the Eurozone countries
Market, especially in times of crisis for all the countries; during the sovereign debt crisis we observe how the credit default swap (CDS) market has increased its influence on the stock market in countries especially affected by this crisis, such as Italy, Portugal and Spain
For each country and zone, we present the number of times that the null hypothesis of Granger causality is rejected. ⇒ indicates that the stock market causes the CDS market, ⇐ indicates that the CDS market causes the stock market and ⇔ indicates that both the stock market and the CDS market cause each other, reciprocally, in a given estimation window. (-) indicates the absence of data for this sub-period
Summary
After the Lehman Brothers default in September 2008, international financial markets experienced devastating distortions, highlighting the importance of the study of risk management, especially credit risk, for both academics and professionals. This interest has been revived in recent years in the context of the European debt crisis, where credit spreads rose to unprecedented levels, to a greater extent in the Eurozone countries. We look into the risk transmission process through the price discovery mechanism The importance of this lead–lag relationship has increased in recent years as credit derivatives have been trading in all financial markets, with CDSs being the most commonly used instrument for the transfer of credit risk
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