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The Age of Turbulence - Credit Derivatives Style

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Abstract

This paper focuses on the many extreme credit default swap spread movements observed during the recent credit crisis and on how the tails of the spread (and price) change distribution significantly differ from those of the normal distribution even for diversified credit derivatives portfolios. Particular focus is put on the sudden shift in the behavior of the credit default swap market in the summer of 2007. During the first month of the crisis, July 2007, we find the extreme turbulence in the credit derivatives market to be comparable only to the turmoil in the equity market in October 1987 and in October 2008. As a result of this extreme behavior and the dramatic regime shift observed in 2007, credit derivatives portfolio Value at Risk estimates based on extreme value theory are found to be much more accurate than those based on normal or historical distributions, both during the crisis and in the comparably tranquil times leading up to the crisis.

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  • Byström, Hans, 2008. "The Age of Turbulence - Credit Derivatives Style," Working Papers 2008:16, Lund University, Department of Economics, revised 16 Jun 2010.
  • Handle: RePEc:hhs:lunewp:2008_016
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    File URL: http://project.nek.lu.se/publications/workpap/Papers/WP08_16.pdf
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    1. McNeil, Alexander J. & Frey, Rudiger, 2000. "Estimation of tail-related risk measures for heteroscedastic financial time series: an extreme value approach," Journal of Empirical Finance, Elsevier, vol. 7(3-4), pages 271-300, November.
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    Keywords

    value at risk; VaR; extreme value theory; credit default swap index; credit crisis; credit derivative;

    JEL classification:

    • C16 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Econometric and Statistical Methods; Specific Distributions
    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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