Shocks from the Subprime Crisis to Bond Indices in the U.S., the EU and Emerging Markets via CDS Indices

Abstract

This paper aims to examine the contagion effects, impulse responses and variance decompositions from subprime asset-backed ABX indices to representative CDS indices and from CDS indices to associated bond indices via the VAR framework of Longstaff (2008) along with representative CDS indices in various regions standing for credit and liquidity risks. The empirical findings show that there are more significant impulse responses, variance decompositions and contagion effects from lower-rated ABX index returns to associated CDS index returns than from higher-rated ABX index returns after the subprime crisis occurred. Thus, the financial authority may enhance the management of lower-rated CDO securitizations to prevent the occurrence of negative impacts on the CDS markets following the financial crisis. After the onset of the subprime crisis, CDS indices were found to be leading the bond market indices, which conforms to the conclusion of Blanco, Brennan and Marsh (2005) and Zhu (2004) that CDS markets lead bond markets. During the outbreak of the crisis, a sharp increase in impulse responses from CDS index returns to bond index returns in emerging markets was observed, as well as a larger rise in the variance ratio from CDS indices to Asian and EMEA emerging market bond indices than to developed market bond indices. This is consistent with the findings of Bae, Karolyi, and Stulz (2003) and Kim and Ying (2007) that emerging markets are more vulnerable to shocks of international financial crises. Moreover, there are more significant contagion effects from CDS indices to Asian emerging market bond indices than to developed markets following the onset of the subprime crisis. In the early stage of the subprime crisis, credit risks are found to exert significantly positive effects on Asian emerging market bond index returns. On the one hand, developed countries may stop rebalancing losses via emerging markets through securitization to prevent a severe global financial crisis. On the other hand, the financial authorities of Asian emerging markets should strive to find a balance between the pursuit of financial market liberalization and the improvement of their characteristics in order to reduce the cross-market linkages of the various financial markets induced by the crisis. In addition, investors may, over the short run, invest in Asian emerging market bonds during the early stages of the financial crisis to disperse portfolios risks, but this investment should be sustained up to the outbreak of the crisis.