Equities, Credits and Volatilities: A Multivariate Analysis of the European Market During the Sub-Prime Crisis
17 Pages Posted: 26 Oct 2009 Last revised: 25 Jun 2012
Date Written: June 25, 2012
We study the lead-lag dependence between aggregate credit spreads and equity prices as well as implied equity volatility, which is important for proper credit risk assessment. Our analysis includes daily quotes of the iTraxx Europe index, the Dow Jones Euro Stoxx 50 index, and the Dow Jones VStoxx index during the period June 2004 to April 2009, i.e. before and during the subprime financial crisis. We robustly estimate a vector autoregressive (VAR) model, allow for time-varying coefficients and assume a multivariate autoregressive conditional heteroskedastic (ARCH) model of the BEKK-type for the innovations. We find that while the commonly predicted negative relation between asset prices and credit spreads holds during the pre-crisis period, it fails to hold during the subsequent crisis period. Equity returns turn out to be insignificant predictors of spreads during the crisis and spread changes significantly and positively lead changes in equity market volatility. Hence, while information in aggregate spreads is typically not driving aggregate market risk, it well may do so during a period in which severe stress in credit markets spills over to the equity market. In sum our results cast some doubt on the stability of the predictions of structural models of credit risk during periods of market stress.
Keywords: credit risk, credit default swaps, iTraxx index, vector autoregression, multivariate GARCH, BEKK
JEL Classification: G01, C32
Suggested Citation: Suggested Citation