Option-Implied Correlation between iTraxx Europe Financials and Non-Financials Indexes: A Measure of Spillover Effect in European Debt Crisis

10 Pages Posted: 31 Mar 2012 Last revised: 2 Jul 2013

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

C.S. Lau

The Chinese University of Hong Kong

Date Written: July 2, 2013

Abstract

This paper proposes an analytic method to estimate the option-implied correlation embedded in options on the iTraxx Europe CDS indexes. The option-implied correlation is suggested as a measure of the spillover effect of default risk between the financial and corporate sectors in Europe. In particular, the correlation between the iTraxx Financials and Non-Financials sub-indexes is estimated from option on the iTraxx Main Index, which is considered as a basket option with the two sub-indexes being its underlyings. The abrupt changes of the realized correlation anticipated information of the corresponding option prices. The sovereign default risk, funding liquidity risk, level of risk aversion, and equity market performance are identified to be significant determinants of the option-implied correlation, implying inter-dependence amongst various markets during the European debt crisis.

Keywords: credit default swaps, European debt crisis, option-implied correlation

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Lau, Chun-sing, Option-Implied Correlation between iTraxx Europe Financials and Non-Financials Indexes: A Measure of Spillover Effect in European Debt Crisis (July 2, 2013). Journal of Banking and Finance, Vol. 37, pp. 3694-3703, 2013. Available at SSRN: https://ssrn.com/abstract=2032020 or http://dx.doi.org/10.2139/ssrn.2032020

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Chun-sing Lau

The Chinese University of Hong Kong ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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