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The co-integration of CDS and bonds in time-varying volatility dynamics: do credit risk swaps lower bond risks?

The co-integration of CDS and bonds in time-varying volatility dynamics: do credit risk swaps... AbstractThis study analyzes the co-integration relationship between sovereign bonds and credit default swaps (CDS) and then examines the impact of CDS-bond deviation from the relationship on market volatility using the Markov-switching approach. Our empirical sample consists of the daily CDS premium and bond yield spread obtained with the DataStream database for the period from 2008 to 2014. Our empirical results show that the absolute value of the CDS-bond deviation is positively related to the probability of a high volatility regime and negatively related to the probability of a low volatility regime. This result implies a positive association between the CDS-bond deviation and the volatility in the CDS-bond market. Our findings are consistent across mature-market and emerging-market countries. Moreover, the evidence we uncover suggests that the practice of managing default risk of bonds via the use of CDS may increase the interest rate risk of the bond, which implies both wins and woes from the introduction of CDS, particularly for mature-market countries. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Studies in Nonlinear Dynamics & Econometrics de Gruyter

The co-integration of CDS and bonds in time-varying volatility dynamics: do credit risk swaps lower bond risks?

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Publisher
de Gruyter
Copyright
© 2021 Walter de Gruyter GmbH, Berlin/Boston
ISSN
1558-3708
eISSN
1558-3708
DOI
10.1515/snde-2019-0141
Publisher site
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Abstract

AbstractThis study analyzes the co-integration relationship between sovereign bonds and credit default swaps (CDS) and then examines the impact of CDS-bond deviation from the relationship on market volatility using the Markov-switching approach. Our empirical sample consists of the daily CDS premium and bond yield spread obtained with the DataStream database for the period from 2008 to 2014. Our empirical results show that the absolute value of the CDS-bond deviation is positively related to the probability of a high volatility regime and negatively related to the probability of a low volatility regime. This result implies a positive association between the CDS-bond deviation and the volatility in the CDS-bond market. Our findings are consistent across mature-market and emerging-market countries. Moreover, the evidence we uncover suggests that the practice of managing default risk of bonds via the use of CDS may increase the interest rate risk of the bond, which implies both wins and woes from the introduction of CDS, particularly for mature-market countries.

Journal

Studies in Nonlinear Dynamics & Econometrics – de Gruyter

Published: Jun 1, 2022

Keywords: CDS; Markov-switching model; Sovereign bonds; VECM; volatility; G15; G12; C53

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