Abstract
Abstract Using copula methods and simulation-based inference, the authors investigate the association between the performance of a stock index formed by European financial institutions and a basket of CDS contracts of the same sector. Their analysis focuses on (i) assessing the dependence structure of the markets when extreme events occur, and (ii) checking the validity of the conclusion by Merton (On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, 1974) and other similar structural models that there is an intensification of the relationship between stock prices and credit spreads after large negative shocks in the value of firms’ assets. The authors show that there is a large tail dependence between the two portfolios. However, the dependence structure seems to be similar with respect to positive and negative innovations in the indexes. Their findings suggest that credit models’ implications do not apply to financial firms, likely because the implicit subsidies from governments to financial institutions are distorting the dependency structure.
Highlights
The market for credit derivatives, and in particular the market for credit default swaps ( CDS), has experienced remarkable development over the last two decades
Our research addresses the interaction between the credit risk and the performance of financial stocks
Longstaff et al (2003) examine Granger causality between changes of CDS spreads, changes of bond credit spreads, and stock returns. Their analysis focuses on US markets, and the results indicate that stock markets and CDS markets led corporate bond markets
Summary
The market for credit derivatives, and in particular the market for credit default swaps ( CDS), has experienced remarkable development over the last two decades. These markets are often seen as very opaque due to the lack of formally established clearing and settlement mechanisms providing reliable information on prices or volumes. The turnover of CDS markets has surged over the years, mostly through transactions executed over-the-counter. The transparency of these operations is a concern for financial supervisors, who fear that the concentration of massive risk-taking by a small group of financial intermediaries might jeopardize financial stability. The role of these markets in the recent financial crisis has been widely scrutinized by the policy makers and has had extensive media coverage, after the AIG bail-out
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