Price Discovery between Credit Default Swap and Foreign Exchange Markets: Unidirectional or Bidirectional Granger Causality?

Abstract

This study investigates Granger causality in mean and variance between the corporate credit default swap (CDS) and foreign exchange markets. Using an error correction model, vector autoregressive model and Hong’s (2001) test, we document strong evidence of bidirectional Granger causality in mean and variance between the three CDS indices and 45 countries in the sample. The significance of the results is found to depend on the credit quality of the underlying CDS indices’ entities, with investment grade CDS entities showing more significant Granger causality results than non-investment grade CDS entities. These results are found to be most significant post-global financial crisis. Furthermore, the significance of the Granger causality in mean results is found to rely on the choice of econometric model; Hong’s (2001) is found to be the most significant, followed by the ECM approach, and last VAR models.

JEL Classification: Granger causality, Risk spillover, Information transmission, CDS market, Foreign exchange market, Pr