Cross-Hedging Strategies between CDS Spreads and Option Volatility during Crises

Abstract

This paper presents a joint analysis of the term structure of credit default swap (CDS) spreads and the implied volatility surface for European countries during 2007-2012, a sample period covering both the Global Financial Crisis and the European debt crisis. We analyze to which extent cross-hedges can be performed between the credit and volatility markets during these two crises. We find that during a crisis we may experience a breakdown of the relationship between credit and volatility markets which jeopardizes any cross-hedging strategy. Consequently, an impairment of this intrinsic relationship may occur depending on the underlying crisis.

Keywords: Credit Default Swap, Term Structure, Implied Volatility Surface, Factor Decomposition, Market Linkages, Cross-Hedging

JEL Classification: C14, C58, G12, G13