A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium
53 Pages Posted: 16 Jan 2011 Last revised: 21 Jan 2012
There are 3 versions of this paper
A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium
A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium
A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium
Date Written: November 15, 2010
Abstract
Using a Markov switching unobserved component model we decompose the term premium of the North American CDX investment grade index (CDX-IG) into a permanent and a stationary component. We explain the evolution of the two components in relating them to monetary policy and stock market variables. We establish that the inversion of the CDX index term premium is induced by sudden changes in the unobserved stationary component, which represents the evolution of the fundamentals underpinning the probability of default in the economy. We find strong evidence that the unprecedented monetary policy response from the Fed during the crisis period was effective in reducing market uncertainty and helped to steepen the term structure of the index thereby mitigating systemic risk concerns. The impact of stock market volatility in flattening the term premium, as captured by the VIX index, was substantially more robust in the crisis period. We also show that equity returns make a substantial contribution to the term premium over the entire sample period.
Keywords: Credit Default Swap Index, Markov Switching, State-Space, Variance Decomposition
JEL Classification: G01, G12, G15, C22, C24, C58
Suggested Citation: Suggested Citation
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