Default correlation at the sovereign level: evidence from some Latin American markets

Abstract

Using the eruption of Argentina debt crisis in 2001 as a natural experiment, we investigated the correlated default at the sovereign level for some Latin American countries. Daily closing market quotes for sovereign Credit Default Swaps (CDS) of Argentina, Brazil, Mexico and Venezuela were obtained from CreditTrade database. Using copula approach, we observed increased dependences among sovereign CDS markets during the crisis period. Their dependence structures were found to be asymmetric. Moreover, the degree of credit contagion was related to the creditworthiness of the country. This study also discussed the implications of these findings for policymakers.

Notes

¹ For example, as mentioned in Ene and Vlad (2002), 2 months before the actual news of the collapse of Enron was out, the default swap markets had already begun pricing it.

² See Dages et al. (2005), an overview of the emerging market credit derivatives market, Federal Reserve Bank of New York Working Paper.

³ Correlations calculated with equal weights assigned to small and large returns are not appropriate for evaluation of return dependence on which extreme values may have different impacts.

⁴ Choosing a high value of threshold leads to few observations of return exceedances, and implies inefficient parameter estimates with large SEs. On the other hand, choosing a low value of threshold leads to many observations of return exceedances, though it induces biased parameter estimates. Hence, Longin and Solnik (2001) applied Monte Carlo simulation to determine the optimal threshold values.

⁵ For bivariate model in the EVT, there are typically seven parameters to be estimated: two tail probabilities, two dispersion parameters, two tail indexes, and the dependence parameter.

⁶ Gumbel copula has only upper tail dependence.

⁷ We understand that Pearson correlation indicates the strength of a linear relationship between two variables. Its value alone is not sufficient to evaluate the relationship in our dataset. We use it to enquire whether correlations are under- or overstated, if data are nonlinear. Similarly, the nonparametric rank correlations, Kendall and Spearman measures, are less sensitive to the observations in the tails. We calculate all these measures as preliminary tests of correlations and mainly for the purpose of comparison. It strengthens the need for copula analysis.

⁸ Investment-grade rating promotes holdings from investors such as mutual funds or pension funds with restricted investment policies

⁹ Fitch first upgraded Mexican sovereign bond from double B plus to triple B minus in January 2002, while Moody's upgraded it from Baa3 to Baa2 in February 2002. Standard and Poor (S&P) reacted promptly the next day after Moody's announcement.