Long-Run Risk Dynamics, Instabilities, and Breaks on European Credit Markets over a Crisis Period

Abstract

This article investigates the role of the long-run determinants of European corporate credit default swap (CDS) spreads during the recent financial crisis. The authors divide the determinants of CDS spreads into systematic and idiosyncratic factors and propose an equilibrium model that accommodates the occurrence of structural breaks in the long-run relationship between the variables. These breaks, interpreted as outlying observations, are endogenously determined within unit root specifications used to describe the dynamics of the explanatory factors.

The authors observe that crisis shocks are persistent and have the potential to change long-run equilibrium dynamics. The systematic credit risk factor is proxied by the European iTraxx portfolio, and the idiosyncratic factor, by the stock price corresponding to each CDS contract. Exogeneity tests applied to this novel econometric specification reveal that, for these contracts, the credit risk discovery process is in the factors, not in the CDS market. R-squared measures corresponding to the vector error-correction representation of the equilibrium model confirm the strong predictive ability of the iTraxx portfolio and the error-correcting vector for changes in the CDS spreads. Stock returns do not exhibit predictive power, however.

TOPICS: Credit default swaps, financial crises and financial market history, VAR and use of alternative risk measures of trading risk