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

Fei, F., Fuertes, A. & Kalotychou, E. Dependence in Credit Default Swap and Equity Markets: Dynamic Copula with Markov Switching. International Journal of Forecasting,

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Abstract

We propose a flexible dynamic copula with Markov-switching to model the dependence between the iTraxx Europe CDS market and the underlying equity market. The model is able to reproduce extreme return clustering and asymmetry by allowing for two time-varying dependence regimes, low or "normal" and high or "crash", both at the centre and tails of the bivariate distribution. In-sample statistical criteria support the Markov-switching dynamic copula. Empirically, we identify high dependence regimes that coincide with the recent credit crunch and the Greek and European sovereign debt crises. A portfolio Value-at-Risk simulation to generate one-day-ahead trading limits highlights the economic significance of the proposed copula through regulatory loss functions that consider the frequency and the magnitude of out-of-sample exceptions.

Item Type: Article
Uncontrolled Keywords: Credit spread; Copula; Regime switching; Tail dependence; Value-at-Risk
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School > Faculty of Finance
URI: http://openaccess.city.ac.uk/id/eprint/17038

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