RELATIONSHIP BETWEEN SOVEREIGN CREDIT DEFAULT SWAP AND STOCK MARKETS- The Case of East Asia

• Main Authors: Basazinew, Serkalem Tilahun, Vashkevich, Aliaksandra
• Format: Others
• Language: English
• Published: Umeå universitet, Företagsekonomi 2013
• Subjects: sovereign credit risk; credit default swap; stock index; Merton model; price discovery; capital structure arbitrage; emerging market.
• Online Access: http://urn.kb.se/resolve?urn=urn:nbn:se:umu:diva-80844

When adjusted to sovereign entities, the structural credit risk model assumes a negative (positive) relationship between sovereign CDS spreads and stock prices (volatilities). In theory both markets are supposed to incorporate new information simultaneously. Discrepancies from the theoretical relationship can be exploited by capital structure arbitrageurs. In our thesis we study the intertemporal relationship between sovereign CDS and stock index markets in East Asia during the period of 2007 – 2011. We detect a negative (by and large positive) relationship between the Asian CDS spreads and stock indexes (volatilities). Across the whole region the sovereign CDS market dominates the price discovery process. However, 4 out of 7 Asian countries (Japan, Korea, Malaysia and the Philippines) demonstrate a feedback effect. The stock markets of countries with higher credit spreads (Indonesia, the Philippines and Korea) appear to react more severely at heightened variance in the CDS market. When considered separately for turbulent vs. calm periods, we find that the lead-lag relationship between the Asian sovereign CDS and stock markets is not stable. Apart from that, both markets become more interrelated during periods of increased volatility. The dependency of Asian CDS spreads and stock indexes on the “fear index” detected in the frames of robustness check implies an integration of both markets into the global one. Therefore, while seeking for arbitrage opportunities in the respective Asian markets one should also take into account possible influences of broader global factors.