Regimes in CDS Spreads: A Markov Switching Model of iTraxx Europe Indices
AbstractThis paper investigates the determinants of the iTraxx CDS Europe indices, finding strong evidence that they are regime dependent. During volatile periods credit spreads become highly sensitive to stock volatility and more sensitive to this than to stock returns. They are also almost immune to interest rates changes. During tranquil periods credit spreads are more sensitive to stock returns than to volatility and most indices are sensitive to interest rate moves. However for companies in the financial sector interest rates have no significant influence in either regime. We also found some evidence that raising interest rates can decrease the probability of credit spreads entering a volatile period. Our findings are useful for policy makers and, since equity hedge ratios based on single-state models cannot capture the regime dependent behaviour of credit spreads, our results may also help traders to improve the efficiency of hedging credit default swaps. Finally, the volatility clustering and autocorrelation that we have identified in the price dynamics of iTraxx indices should prove useful for pricing the iTraxx options that are now being actively traded over-the-counter.
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Bibliographic InfoPaper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2006-08.
Length: 27 Pages
Date of creation: Sep 2006
Date of revision:
Publication status: Forthcoming in Journal of Banking and Finance
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More information through EDIRC
iTraxx; Credit Default Swap Index; Markov Switching; Credit Spreads;
Find related papers by JEL classification:
- C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
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