Time-varying Co-movements and Contagion Effects in Asian Sovereign CDS Markets

Abstract

(ProQuest: ... denotes formulae omitted.)I. INTRODUCTIONCredit default swap (CDS) has been one of the fastest growing derivatives in global financial markets for the last decade. A sovereign CDS provides insuranc by securing principal of the bond. For that reason, the sovereign CDS spread1 proxies the risk of the country's financial market as well as its economic situation. From the protection seller's perspective, the CDS spread represents the expected loss from the swap contract. Therefore, a rise in the spread of sovereign CDS indicates a higher probability of expected loss or credit events; the CDS spread can be a useful indicator of a country's credit risk. A number of earlier studies have focused on this aspect. For instance, Hull, Predescu and White (2004) report that changes in the CDS spread are useful in forecasting credit downgrade. Furthermore, it has been argued that CDS markets hold a dominant position over bond markets when it comes to price discovery function: See Blanco et al. (2005), Zhu (2006) and Ammer and Cai (2007).In contrast, the negative aspects of sovereign CDS have been criticized because speculative transactions may generate sudden upward swings in the CDS spread of a particular country. In addition, it has been noted that naked CDS investors-who purchase CDSs only for speculative purposes without possessing the bond-may manipulate the market and cause excessive price increases. The EU has regarded them as one of the factors that provoked the European financial crisis and eventually, at the end of 2012, enforced a regulation to prohibit sovereign CDS trading by naked CDS investors.Considering the economic fundamentals in some emerging economies in East and Southeast Asia, the sovereign CDS spreads in the region fluctuated significantly on the day following the Lehman Brothers bankruptcy: Korea (14.1bp), Philippines (14.7bp), Indonesia (15.2bp) and Malaysia (13.7bp); and on the day following the US credit downgrade: Korea (20.95bp), Philippines (29.99bp), Indonesia (27.09bp) and Malaysia (17.68bp). Dynamic and fast growing Asian emerging economies are susceptible to global variables with a larger volatility. Hence, we cannot rule out the possibility of contagion effects with which a sharp rise in the CDS spread in one nation may be transmitted to other countries, generating higher sovereign default risk in the entire region.Previous literature on the CDS spread mainly analyzes the determinants of the CDS spread. For instance, Duffie (1999), Elton et al. (2001), Huang and Huang (2003) and Longstaffet al. (2005) analyze the relationship between the CDS spread and bonds. Alexander and Kaeck (2008) and Zang et al. (2009) find that the stock market risk is a determinant of the changes in the CDS spread.2 In terms of systemic risk, Lown and Morgan (2006) analyze the impact of credit cycles on the business cycles. However, Gorton and He (2008) argue that credit cycles have their own dynamics separate from business cycles. Despite the plethora of studies on the determinants of the CDS spread-and as a part of such attempts, investigation on the relationship between the CDS spread and other financial markets such as the stock market or foreign exchange market-research on the interconnectedness among sovereign CDS spreads from different countries is rare. The only exception is the work by Gunduz and Kaya (2013), which discovers the co-movement of CDS spreads in ten Eurozone countries by using the Dynamic Conditional Correlation (DCC) model suggested by Engle (2002).The purpose of this paper is to investigate this rarely recognized phenomenonthe interconnectedness of sovereign CDS spreads and the contagion of default risk. To do that, we analyze the co-movements and spillovers in seven Asian sovereign CDS markets after the 2007 global financial crisis. We employ the corrected Dynamic Conditional Correlation (cDCC) model by Aielli (2013), an improved version the DCC model, and identify the correlation among the CDS spreads in our sample countries. …