Is Jump Risk in iTraxx Sector Indices Diversifiable?

Abstract

Previous research on credit risk mainly focuses on the prediction of default probability and most of these are based upon bond market analyses. The rapid development of the credit derivatives market make research on credit risk using information from this market more important and attractive. Also, over the last few years, analysis of dynamic behavior of credit risk has become important among academics, practitioners, and regulators. This article focuses on the investigation of nondiversifiable jump risk in iTraxx sector indices based on a multivariate framework that explicitly admits discrete common jumps for an index and its components. Our empirical research shows that both the sector iTraxx indices and the iTraxx Non-Financials, which acts as an index for the sector, experience jumps during sample period. This means that the jump risks in the iTraxx sector index are not diversifiable. Such a result warrants further investigation on credit risk, for example, in pricing and prediction.

TOPICS: Credit risk management, credit default swaps, statistical methods, factor-based models