Empirical Tests on the Credit Default Swap and Stock Markets During the Global Credit Crisis

Abstract:     
This study investigates the time-series dynamics governing the credit default swap indices (CDX), and volatility spillover between the stock and CDX markets. We use daily returns data on an equally weighted NYSE-AMEX-NASDAQ daily stock index, the CDX investment-grade index (CDXIG) and the CDX high-yield index (CDXHG) over the period between January 2006 and December 2009. Our empirical evidence suggests the presence of two components – (i) diffusive stochastic volatility; and (ii) jumps in returns and volatility – in both the stock and CDX markets. Furthermore, our results show that the contemporaneous correlation between the stochastic volatilities of the stock and CDXIG markets decreased during the recent global credit crisis, suggesting greater diversification benefits between the stock and investment-grade CDX markets in periods of financial downturn. We also find evidence of bi-directional Granger-causality between the stochastic volatilities of the stock and CDX markets during the global credit crisis.

Number of Pages in PDF File: 55

Keywords: Credit default swap, Stochastic Volatility, Jump-diffusion, Volatility Spillover, MCMC

JEL Classification: C11, C15, G01, G1, G12

working papers series