۱- Introduction

۲- Brief review of the literature

۳- Methodology

۴- Data and stochastic properties

۵- Empirical results

۶- Conclusions

References

Abstract

This paper examines the dependence and causal nexuses between ten U.S. credit default swaps and their corresponding stock sectoral markets, using the Quantile-on-Quantile (QQ) approach and the nonparametric causality-in-quantiles tests. The results, using the QQ approach, show asymmetric negative association between credit and markets for all industries and that the link depends on both the sign and size of the stock market shocks (i.e., bullish or bearish conditions in the CDS and/or stock markets). The sensitivity of CDS returns to stock markets shocks is higher in the extreme quantiles. Using the nonparametric causality-in-quantile tests, we find evidence of causality-in-mean from stock to CDS only for the Financial (in average and upper quantiles), Consumer Services and Oil & Gas sectors (only for the middle quantile i.e., 0.5). In addition, the causality-in-mean from the CDS to stock markets is only found for the Financial and Telecommunication sectors in the extreme lower quantiles. Finally, we find a bidirectional Granger causality-invariance for all the CDS-equity sector pairs.

Introduction

The dependence between stock markets and credit default swap (CDS) spreads has re-emerged as a more challenging and interesting area of research in the wake of the global financial crisis (GFC) of 2008–۲۰۰۹ and the European sovereign debt crisis (ESDC) of 2010–۲۰۱۲٫ During this period, the CDSs are called weapons of mass destruction due to their associations with those grave crises.1 These concerns had caused a steady reduction in the size of the global credit derivatives market, which started in 2007, and continued in the first half of 2015. This reflects a contraction in inter-dealer activity. The notional amount of the outstanding credit derivatives contracts fell from $16 trillion at the end of December 2014 to $15 trillion at the end of June 2015, which constitutes only a quarter of its peak of $58 trillion at the end of 2007 (BIS, 2015).2 The widening of sovereign and corporate CDS spreads to unprecedented levels during the GFC had stoked the heightened concerns over default risk, particularly in the financial industry and for countries with gloomy macroeconomic outlooks and serious fiscal imbalances. Considered as the most controversial financial instruments created over the past two decades, the CDSs are strongly supported by some market participants, while blamed by others including researchers.3 On the positive side, some researchers view them as efficient instruments that have processed information rapidly before and after the recent credit crisis. On the other side, researchers such as Subrahmanyam et al. (2014) argue that CDSs have played a leading role in the bankruptcy of Lehman Brothers on September 15, 2008 and in the Eurozone sovereign debt crisis (ESDC) that started in Greece in late 2009 and spread into Europe. To others, those derivatives had shown under-reaction during the GFC but in the latter stages of this crisis they overreacted although the overreaction was shorted lived. Thus, researchers call the efficiency of those credit derivatives into question during less stable economic periods (Jenkins et al., 2016). Theoretically, the structural model of credit risk proposed by Merton (1974) offers a theoretical framework that supports the link between CDS and stock markets. According to this model, default occurs when a firm’s value, which is perceived to follow a stochastic process, goes below a certain threshold. This value is unobserved and its changes cannot be measured directly, but changes in the firm’s stock value are widely accepted as good proxies for changes in the firm’s value. The Merton model asserts that that a drop in stock returns is accompanied by an increase in the firm’s CDS spread. Thus, this structural model suggests that CDS spreads and stock prices have a negative relationship with each other and co-move to prevent arbitrage from taking place. The deterioration in the financial conditions of a firm increases the probability of its default on the underlying debt obligations, and that financial distress conditions result in a decrease in the value of firms’ stocks and an increase in the CDS spread.