CDX and iTraxx and their relation to the systemically important financial institutions: Evidence from the 2008-2009 financial crisis

This paper empirically investigates the linkages between the CDS index market and the equity returns of a sample of systemically important financial institutions (SIFIs). Both the 5- year investment grade iTraxx Europe and the 5-year investment grade CDX North America indexes are adopted as a market consensus of the overall credit risk in the financial system. Through a multivariate VAR model using historical data, the investigation uncovers three key findings. First, the equity returns for all systematically important institutions are inversely associated to shocks in the CDS index market. Second, European institutions demonstrate a stronger connection with the iTraxx whilst the US institutions are more closely related to the CDX. Furthermore, volatility originating in the CDS index market is unambiguously transmitted to both the insurance and the banking sector. Third, US banks are most severely distressed by the volatility transmission mechanism whilst European insurers are least affected

Liquidity spillovers in sovereign bond and CDS markets: an analysis of the Eurozone sovereign debt crisis

At the end of 2009, countries in the Eurozone (euro area) began to experience a sudden divergence of bond yields as the market perception of sovereign default risk increased. The theory of complete markets suggests that sovereign debt and credit default swap (CDS) credit spreads should track each other closely. In addition, liquidity risk should be priced into both instruments in such a way that buying exposure to the same default risk is identically priced. We use a time-varying vector autoregression framework to establish the credit and liquidity spread interactions over the 2009-2010 crisis period. We find substantial variation in the patterns of the transmission effect between maturities and across countries. Our major result is that, for several countries, including Greece, Ireland and Portugal the liquidity of the sovereign CDS market has a substantial time varying influence on sovereign bond credit spreads. This evidence is of particular importance in the current policy context. © 2011 Elsevier B.V

Credit derivatives and the default risk of large complex financial institutions

This paper proposes and implements a multivariate model of the coevolution of the first and second moments of two broad credit default swap indices and the equity prices of sixteen large complex financial institutions. We use this empirical model to build a bank default risk model, in the vein of the classic Merton-type, which utilises a multi-equation framework to model forward-looking measures of market and credit risk using the credit default swap (CDS) index market as a measure of the conditions of the global credit environment. In the first step, we estimate the dynamic correlations and volatilities describing the evolution of the CDS indices and the banks’ equity prices and then impute the implied assets and their volatilities conditional on the evolution and volatility of equity. In the second step, we show that there is a substantial ‘asset shortfall’ and that substantial capital injections and/or asset insurance are required to restore the stability of our sample institutions to an acceptable level following large shocks to the aggregate level of credit risk in financial markets

Short-term determinants of the idiosyncratic sovereign risk premium: a regime-dependent analysis for European credit default swaps

This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility

The term structure of sovereign credit default swap and the cross‐section of exchange rate predictability

We provide novel evidence on exchange rate predictability by using the term premia of the sovereign credit default swap (CDS). Using a sample of 29 countries, we find that the sovereign CDS term premia significantly predict the exchange rates out‐of‐sample. On average, a steeper CDS spread curve for a country predicts its currency appreciation against the U.S. dollar (USD). Empirically, although the sovereign CDS level mainly reflects global risk, the information in the term premia of the sovereign CDS spreads reveals country‐specific risk. Notably, the predictive power of the term premia is robust after controlling for the sovereign CDS level and other conventional global macroeconomic and financial factors. Further analysis shows that the information in the sovereign CDS term premia is also helpful for forecasting international stock market returns

Exploring risk premium factors for country equity returns

In this paper, we study a comprehensive set of risk premia of country equity returns for 45 countries over the sample period 2002 to 2018 in both a single and a multiple factor setting. Using a new three-pass estimation method for factor risk premia by Giglio and Xiu (2021), we find that several factors, including default risk, are also priced in country equity excess returns, controlled by the Fama–French 5-factor and Carhart model. Moreover, we apply a novel approach to investigate the multi-factor impact on country equity returns. We find that the multi-factor information, constructed from the first principal component of the statistically significant single factors, provides a consistent and stronger prediction of anomalies in country equity returns

An empirical analysis of the impact of the credit default swap index market on large complex financial institutions

This paper contributes to the primarily empirical literature by conducting the first extensive empirical analysis of the impact of the degree of co-movement in the main standardized credit default swap (CDS) indices on the group of large complex financial institutions (LCFIs). We attempt to account for the dynamics between banks' equity returns and most liquid CDS market indices, the investment grade 5-year CDX North America and the investment grade 5-year iTraxx Europe, through conditioning our analysis on the historical correlation between the variables. Our most important findings are threefold. First, we find that equity returns for all the LCFIs are negatively correlated to both the CDX and the iTraxx indices. Second, the CDX index is the dominant factor driving shocks across all the LCFIs and this effect is stronger for European than US banks. Third, the impact of CDS market volatility on the equity return volatility of LCFIs appears very pronounced, suggesting a transmission mechanism which results in the destabilisation of banks and a subsequent increase in their default risk. © 2012 Elsevier Inc

The effects of supervisory stress testing on bank lending: examining large UK banks

In this paper, we study the effects of supervisory stress test exercises on 19 UK banks over the 2005–2018 period. The novelty of our approach is that we include two stress testing timelines from two banking supervisory authorities. Using a difference-in-difference methodology, in a first step, we analyse the effects of the Bank of England’s stress tests on the lending behaviour of large UK banks. In a second step, for robustness, we also examine the stress tests administered by the European Banking Authority. Our main result is that banks that failed the stress tests reduced lending. Additionally, we show that the effectiveness of the stress tests exercises remained unchanged throughout the period.</p

Sovereign credit default swaps and the currency forward bias

We study the links between sovereign credit risk and the currency forward bias. In a setting of defaultable sovereign bonds, we show that the forward bias can be negatively linked to sovereign credit risk. We confirm empirically that the forward bias is negatively associated to sovereign CDS spreads and systematically across both developed and emerging countries but the effect is more pronounced for emerging countries. Furthermore, we show that the forward bias decreases after the inception of the sovereign CDS market. Overall, our results underscore the distinct role of the sovereign CDS market in enhancing price efficiency in currency forward and spot markets.</p

US national banks and local economic fragility

We examine the relationship between US national banks’ local market shares and the economic fragility of the counties in which they operate. We find that counties with national banks that have large local market shares experience a greater fluctuation in their income growth in the subsequent year. Further, an increase in income growth is more pronounced during normal times but declines significantly in a distressed market. We further find that the national banks create greater liquidity during normal times and lower liquidity in distressed times. Overall, our results indicate that national banks may expose local economies to macro-level distress.</p