A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium

53 Pages Posted: 16 Jan 2011 Last revised: 21 Jan 2012

See all articles by Giovanni Calice

Giovanni Calice

Bangor Business School

Christos Ioannidis

University of Bath-Department of Economics

Rong Hui Miao

University of Bath - Department of Economics

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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

Calice, Giovanni and Ioannidis, Christos and Miao, Rong Hui, A Markov Switching Unobserved Component Analysis of the CDX Index Term Premium (November 15, 2010). Available at SSRN: https://ssrn.com/abstract=1741297 or http://dx.doi.org/10.2139/ssrn.1741297

Giovanni Calice (Contact Author)

Bangor Business School ( email )

Bangor Business School
College Road
LL57 2DG
United Kingdom

Christos Ioannidis

University of Bath-Department of Economics ( email )

Claverton Down
Bath, BA2 7AY
United Kingdom

Rong Hui Miao

University of Bath - Department of Economics ( email )

Department of Economics
University fo Bath
Bath, BA2 7AY
United Kingdom

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