An asymmetric DCC analysis of correlations among bank CDS indices

Abstract

This study explores the time-varying correlations among the bank industry Credit Default Swap (CDS) indices for the EU, the UK and the US, using the asymmetric Dynamic Conditional Correlation (DCC) model developed by Cappiello et al. (2006). The main findings of the study include: (i) The correlations between each pair of bank CDS indices vary substantially over time. (ii) There is evidence of asymmetric dynamic correlations between the EU and the UK bank CDS indices. The correlations between them tend to be higher when responding to joint downward shocks. (iii) The conditional correlations between the US bank CDS and the UK and the EU bank CDS, respectively, exhibited significant drops immediately after the collapse of Lehman Brothers during the global financial crisis. (iv) The sovereign debt crisis dummy in Autoregressive (AR) models, applied to the estimated DCCs, is significantly positive for the UK and US bank CDSs, as shown by the increased correlations after the onset of the debt crisis.

Keywords:

• credit default swaps (CDS)
• bank sector CDS
• asymmetric DCC
• EGARCH
• financial crisis

JEL Classification::

• F30
• G15
• C51

Notes

¹ Dungey and Martin (2007) provide a list of the related empirical financial crisis literature in detail.

² The bank sector CDS indices incorporate an average mid-spread calculation of a portfolio of single-named CDS for several banks. Among the CDS indices ranging in maturity from 1 to 10 years, the 5-year CDS index is the most actively traded.

³ Wang and Moore (2012), who analysed the sovereign CDS markets with the DCC framework, used weekly observations as well.

⁴ See Jarque and Bera (1987).

⁵ The results of the unit root tests are available upon request.

⁶ In contrast, most parameters in the mean equations are not significant at a 5% level. However, we think this is not a major concern because our study primarily focuses on the dynamics of the correlations and hence is concerned only with the fit of the variance equations.

⁷ See Ljung and Box (1978).

⁸ For an application of the asymmetric DCC approach, refer to, e.g. Toyoshima et al. (2012).

⁹ We select 9 August 2007 as the beginning of the global financial crisis, when BNP Paribas suspended its funds badly affected by their exposures to the US subprime mortgage liabilities. We also assume that the post-Lehman global financial crisis began after 15 September 2008, when Lehman Brothers went bankrupt. Furthermore, 5 November 2009 is chosen as the onset of the sovereign debt crisis because of Greece's disclosure of its fiscal deficit amounting to twice the size announced previously, triggering investors’ concerns about solvency issues.