Pairing market risk with credit risk
AbstractThis paper uses an exclusive proprietary data set of European Credit Derivatives and VIX markets, covering a sample of 5 to 7 years, to study the nature of the theoretical link between credit risk and market risk, originally postulated in the work of Merton. This allows us to establish cointegration in the VIX and iTraxx/CDS markets in a demand and supply framework where arbitrageurs exploit temporary equilibrium mispricing following pairs strategies. By shorting the outperformer and buying the underperformer asset, arbitrageurs achieve equilibrium price convergence. Profits from pairs strategies, represented via VECM parameters, guarantee positive expected profits. Empirical estimates suggest that temporary mispricing exists due to a lead of VIX in the discovery process. We contribute to the existent literature suggesting that VIX as an improved predictor of CDS spreads.
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Bibliographic InfoPaper provided by Universidad Carlos III, Departamento de Economía de la Empresa in its series Business Economics Working Papers with number wb110201.
Date of creation: Feb 2011
Date of revision:
Pairs strategies; Credit risk; VIX; Price discovery;
Find related papers by JEL classification:
- C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
- G01 - Financial Economics - - General - - - Financial Crises
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-02-19 (All new papers)
- NEP-BAN-2011-02-19 (Banking)
- NEP-CIS-2011-02-19 (Confederation of Independent States)
- NEP-RMG-2011-02-19 (Risk Management)
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