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Credit-default swap rates and equity volatility: a nonlinear relationship

  • Fathi Abid
  • Nader Naifar

Purpose – The aim of this paper is to study the impact of equity returns volatility of reference entities on credit-default swap rates using a new dataset from the Japanese market. Design/methodology/approach – Using a copula approach, the paper models the different relationships that can exist in different ranges of behavior. It studies the bivariate distributions of credit-default swap rates and equity return volatility estimated with GARCH (1,1) and focus on one parameter Archimedean copula. Findings – First, the paper emphasizes the finding that pairs with higher rating present a weaker dependence coefficient and then, the impact of equity returns volatility on credit-default swap rates is higher for the lowest rating class. Second, the dependence structure is positive and asymmetric indicating that protection sellers ask for higher credit-default swap returns to compensate the higher credit risk incurred by low rating class. Practical implications – The paper has several practical implications that are of value for financial hedgers and engineers, loan market participants, financial regulators, government regulators, central banks, and risk managers. Originality/value – The paper also illustrates the potential benefits of equity returns volatility of reference entities as a proxy of default risk. These simplifications could be lifted in future research on this theme.

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Article provided by Emerald Group Publishing in its journal Journal of Risk Finance.

Volume (Year): 7 (2006)
Issue (Month): 4 (August)
Pages: 348-371

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Handle: RePEc:eme:jrfpps:v:7:y:2006:i:4:p:348-371
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