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Regimes in CDS Spreads: A Markov Switching Model of iTraxx Europe Indices

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  • Carol Alexander

    ()
    (Chair in Risk Management)

  • Andreas Kaeck

    ()
    (Graduate Program Finance and Information Management, University of Augsburg and Technical University of Munich)

Abstract

This 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 Info

Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2006-08.

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Length: 27 Pages
Date of creation: Sep 2006
Date of revision:
Publication status: Forthcoming in Journal of Banking and Finance
Handle: RePEc:rdg:icmadp:icma-dp2006-08

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Postal: PO Box 218, Whiteknights, Reading, Berks, RG6 6AA
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Web page: http://www.henley.reading.ac.uk/
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Related research

Keywords: iTraxx; Credit Default Swap Index; Markov Switching; Credit Spreads;

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References

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Cited by:
  1. Niels C. Thygesen & Robert N. McCauley & Guonan Ma & William R. White & Jakob de Haan & Willem van den End & Jon Frost & Christiaan Pattipeilohy & Mostafa Tabbae & Ernest Gnan & Morten Balling & Paul , 2013. "50 Years of Money and Finance: Lessons and Challenges," SUERF 50th Anniversary Volume - 50 Years of Money and Finance: Lessons and Challenges, SUERF - The European Money and Finance Forum, number 1 edited by Morten Balling & Ernest Gnan.
  2. William Arrata & Alejandro Bernales & Virginie Coudert, 2013. "The Effects of Derivatives on Underlying Financial Markets: Equity Options, Commodity Derivatives and Credit Default Swaps," SUERF 50th Anniversary Volume Chapters, SUERF - The European Money and Finance Forum.

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