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

Fei, F., Fuertes, A-M. ORCID: 0000-0001-6468-9845 & Kalotychou, E. (2017). Dependence in Credit Default Swap and Equity Markets: Dynamic Copula with Markov Switching. International Journal of Forecasting, 33(3), pp. 662-678. doi: 10.1016/j.ijforecast.2017.01.006


Theoretical credit risk models à la Merton (1974) predict a non-linear negative link between the default likelihood and asset value of a firm. 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 relative to nested copula models that impose within-regime constant dependence or no regime-switching. Value-at-Risk forecasts that aim to set day-ahead trading limits for the hedging of CDS-equity portfolios reveal the economic relevance of the model from the viewpoints of both regulatory and asymmetric piecewise linear loss functions.

Publication Type: Article
Additional Information: © 2017, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International
Publisher Keywords: Credit spread; Copula; Regime switching; Tail dependence; Value-at-Risk
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School > Finance
SWORD Depositor:
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