Is Tail Risk Priced in Credit Default Swap Premia?

We show that the propensity of a bank to experience extreme co-movements in its credit default swap (CDS) premia together with the market is priced in the bank’s default swap spread during the financial crisis. We measure a bank’s CDS tail beta by estimating the upper tail dependence between its default swap spreads and a CDS market index. Our study shows that protection sellers receive a premium for bearing the risk of extreme upward co-movements in default risk. The economic significance of this effect is large yet limited to the recent financial crisis. Banks in the upper quintile of CDS tail beta have spreads that are on average 140 basis points higher than those of banks in the lower CDS tail beta quintile.

[1]  Fousseni Chabi-Yo,et al.  Crash Sensitivity and the Cross-Section of Expected Stock Returns , 2017 .

[2]  Peter F. Christoffersen,et al.  Dynamic Dependence and Diversification in Corporate Credit , 2016 .

[3]  Tae-Hwan Kim,et al.  VAR for VaR: Measuring Tail Dependence Using Multivariate Regression Quantiles , 2015, SSRN Electronic Journal.

[4]  Dong Hwan Oh,et al.  Modeling Dependence in High Dimensions With Factor Copulas , 2015 .

[5]  Nikolaus Hautsch,et al.  Financial Network Systemic Risk Contributions , 2013 .

[6]  Christophe Hurlin,et al.  A Theoretical and Empirical Comparison of Systemic Risk Measures , 2013 .

[7]  Andrew J. Patton,et al.  Time-Varying Systemic Risk: Evidence From a Dynamic Copula Model of CDS Spreads , 2013 .

[8]  J. Zechner,et al.  The Cross-Section of Credit Risk Premia and Equity Returns , 2013 .

[9]  Peter F. Christoffersen,et al.  Dynamic Dependence in Corporate Credit , 2013 .

[10]  Robert F. Engle,et al.  Volatility, Correlation and Tails for Systemic Risk Measurement , 2010 .

[11]  Frederic A. Schweikhard,et al.  The Impact of Government Interventions on CDS and Equity Markets , 2012 .

[12]  Peter F. Christoffersen,et al.  Is the Potential for International Diversification Disappearing? A Dynamic Copula Approach , 2012 .

[13]  L. Laeven,et al.  Tracking Variation in Systemic Risk at Us Banks During 1974-2013 , 2012 .

[14]  A. Lo,et al.  A Survey of Systemic Risk Analytics , 2012 .

[15]  G. P. Aielli,et al.  Dynamic Conditional Correlation: On Properties and Estimation , 2011 .

[16]  Kris Jacobs,et al.  On Pricing Credit Default Swaps with Observable Covariates , 2011 .

[17]  Rama Cont,et al.  Statistical Modeling of Credit Default Swap Portfolios , 2011 .

[18]  Martin Wieland,et al.  The impact of sovereign credit risk on bank funding conditions , 2011 .

[19]  Francis A. Longstaff,et al.  Counterparty Credit Risk and the Credit Default Swap Market , 2011 .

[20]  Eduardo S. Schwartz,et al.  Are All Credit Default Swap Databases Equal? , 2010, 2202.02273.

[21]  S. Koopman,et al.  Systemic Risk Diagnostics: Coincident Indicators and Early Warning Signals , 2010, SSRN Electronic Journal.

[22]  Xin Huang,et al.  Systemic Risk Contributions , 2010, Journal of Financial Services Research.

[23]  O. D. Jonghe.  Back to Basics in Banking? A Micro-Analysis of Banking System Stability , 2010 .

[24]  J. Annaert,et al.  What Determines Euro Area Bank CDS Spreads? , 2010 .

[25]  L. Pedersen,et al.  Measuring Systemic Risk , 2010 .

[26]  Joost Driessen,et al.  Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market , 2009 .

[27]  T. Kim,et al.  A Longer Look at the Asymmetric Dependence between Hedge Funds and the Equity Market , 2009, Journal of Financial and Quantitative Analysis.

[28]  Gary B. Gorton,et al.  Securitized Banking and the Run on Repo , 2009 .

[29]  Tim Bollerslev,et al.  Tails, Fears and Risk Premia , 2009 .

[30]  Carol Alexander,et al.  Regime dependent determinants of credit default swap spreads , 2008 .

[31]  Sreedhar T. Bharath,et al.  Does Industry-Wide Distress Affect Defaulted Firms? Evidence from Creditor Recoveries , 2007 .

[32]  R. Engle,et al.  The Spline-Garch Model for Low Frequency Volatility and its Global Macroeconomic Causes , 2006 .

[33]  Andrew J. Patton.  Modelling Asymmetric Exchange Rate Dependence , 2006 .

[34]  B. Maris.  An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps , 2006 .

[35]  Roberto Blanco,et al.  An Empirical Analysis of the Dynamic Relation between Investment‐Grade Bonds and Credit Default Swaps , 2005 .

[36]  Hao Zhou,et al.  Explaining Credit Default Swap Spreads With the Equity Volatility and Jump Risks of Individual Firms , 2005 .

[37]  A. McNeil,et al.  The t Copula and Related Copulas , 2005 .

[38]  L. Pedersen,et al.  Demand-Based Option Pricing , 2005 .

[39]  Kris Jacobs,et al.  The Determinants of Credit Default Swap Premia , 2005, Journal of Financial and Quantitative Analysis.

[40]  Pascal J. Maenhout,et al.  Individual Stock-Option Prices and Credit Spreads , 2004 .

[41]  J. Tawn,et al.  Extreme Value Dependence in Financial Markets: Diagnostics, Models, and Financial Implications , 2004 .

[42]  Andrew Ang,et al.  Downside Risk , 2004 .

[43]  R. Engle.  Dynamic Conditional Correlation , 2002 .

[44]  Jan Ericsson,et al.  Liquidity and Credit Risk , 2002 .

[45]  J. Campbell,et al.  Equity Volatility and Corporate Bond Yields , 2002 .

[46]  P. Collin‐Dufresne,et al.  The Determinants of Credit Spread Changes , 2001 .

[47]  D. Duffie,et al.  Floating–Fixed Credit Spreads , 2001 .

[48]  R. Engle.  Dynamic Conditional Correlation : A Simple Class of Multivariate GARCH Models , 2000 .

[49]  F. Longin,et al.  Extreme Correlation of International Equity Markets , 2000 .

[50]  A. Lo,et al.  Nonparametric Risk Management and Implied Risk Aversion , 2000 .

[51]  Martina Metzger,et al.  IMF – International Monetary Fund , 2000, A Concise Encyclopedia of the United Nations.

[52]  D. Duffie,et al.  Modeling term structures of defaultable bonds , 1999 .

[53]  Campbell R. Harvey,et al.  Conditional Skewness in Asset Pricing Tests , 1999 .

[54]  Tyler Shumway.  Explaining Returns with Loss Aversion , 1997 .

[55]  D. Duffie,et al.  An Econometric Model of the Term Structure of Interest-Rate Swap Yields , 1997 .

[56]  M. Rubinstein.,et al.  Recovering Probability Distributions from Option Prices , 1996 .

[57]  B. Hansen.  Autoregressive Conditional Density Estimation , 1994 .

[58]  Anil K. Bera,et al.  ARCH Models: Properties, Estimation and Testing , 1993 .

[59]  Andrei Shleifer,et al.  Liquidation Values and Debt Capacity: A Market Equilibrium Approach , 1992 .

[60]  D. Dickey,et al.  Testing for unit roots in autoregressive-moving average models of unknown order , 1984 .

[61]  Philip H. Dybvig,et al.  Bank Runs, Deposit Insurance, and Liquidity , 1983, Journal of Political Economy.

[62]  A. Christie,et al.  The stochastic behavior of common stock variances: value , 1982 .

[63]  R. Engle.  Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom inflation , 1982 .

[64]  A. Tversky,et al.  Decision, probability, and utility: Prospect theory: An analysis of decision under risk , 1979 .

[65]  R. Litzenberger,et al.  SKEWNESS PREFERENCE AND THE VALUATION OF RISK ASSETS , 1976 .

[66]  B. M. Hill,et al.  A Simple General Approach to Inference About the Tail of a Distribution , 1975 .

[67]  J. Lintner.  THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS , 1965 .

[68]  W. Sharpe.  CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK* , 1964 .

[69]  A. Roy.  Safety first and the holding of assetts , 1952 .

[70]  A. Tversky,et al.  Prospect Theory : An Analysis of Decision under Risk Author ( s ) : , 2007 .

[71]  C. Benkert.  Explaining credit default swap premia , 2004 .

[72]  Armelle Guillou,et al.  A diagnostic for selecting the threshold in extreme value analysis , 2001 .

[73]  R. Engle.  Arch Models " , 1999 .