Dependence in Credit Default Swap and Equity Markets: Dynamic Copula with Markov-Switching

42 Pages Posted: 15 Oct 2012 Last revised: 12 Jan 2017

See all articles by Fei Fei

Fei Fei

Barclays

Ana-Maria Fuertes

Cass Business School, City University of London

Elena Kalotychou

Cass Business School, City, University of London

Date Written: October 26, 2016

Abstract

Theoretical credit risk models a la Merton (1974) predict a non-linear negative link between a firm's default likelihood and asset value. This motivates us to propose a flexible empirical Markov-switching bivariate copula that allows for distinct time-varying dependence between credit default swap (CDS) spreads and equity prices in “crisis” and “tranquil” periods. The model identifies high dependence regimes that coincide with the recent credit crunch and the European sovereign debt crises, and is supported by in-sample goodness of fit criteria versus nested copula models that impose within-regime constant dependence or no regime-switching. Value at Risk forecasts to set day-ahead trading limits for hedging CDS-equity portfolios reveal the economic relevance of the model from the viewpoint of both regulatory and asymmetric piecewise linear loss functions.

Keywords: Credit spread; Copula; Dependence; Regime switching; Tail dependence; Value-at-Risk

JEL Classification: C13, C41, G21, G28

Suggested Citation

Fei, Fei and Fuertes, Ana-Maria and Kalotychou, Elena, Dependence in Credit Default Swap and Equity Markets: Dynamic Copula with Markov-Switching (October 26, 2016). International Journal of Forecasting, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2161570 or http://dx.doi.org/10.2139/ssrn.2161570

Fei Fei

Barclays

1 Churchill Place
London, E14 5HP
United Kingdom

Ana-Maria Fuertes (Contact Author)

Cass Business School, City University of London ( email )

Faculty of Finance
106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 207 477 0186 (Phone)
+44 207 477 8881 (Fax)

HOME PAGE: http://www.city.ac.uk/people/academics/ana-maria-fuertes

Elena Kalotychou

Cass Business School, City, University of London ( email )

106 Bunhill Row
London, EC1Y 8TZ
Great Britain

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