Financial derivatives and default dependence: a time-varying copula approach

ABSTRACT

The fast development of financial derivatives links financial institutions more closely. In this paper, we investigate the joint default dependence among financial institutions and its association with the recent development of financial derivatives. Two interesting findings emerge. First, time-varying default risk dependencies of financial institutions are found during our sample period. Second, the fast growth of derivatives markets contributes to the rising correlated default risk among financial institutions and further leads to an increase in systemic risk. We show that the default correlation spike coincides with the boom in the US credit derivatives market.

KEYWORDS:

• Financial derivatives
• default dependence
• dynamic
• copula
• dynamic

JEL CLASSIFICATION:

• G22
• G33

Disclosure statement

No potential conflict of interest was reported by the authors.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

¹ The strong (time-varying) correlation results from connectedness by financial institutions’ asset holdings which are sensitive to market conditions or other latent factors.

² We also apply weighted average default probability and obtain the similar results.

³ We also apply the skewed t copula (Lucas, Schwaab, and Zhang 2014) to capture dependence structure, and the results are similar to Student’s t copula. It suggests that Student’s t distribution can model dependence between the two sectors well enough.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China [No.71801117,No.71973162]; The Applied Economics of Nanjing Audit University of the Priority Academic Program Development of Jiangsu Higher Education Institutions (Office of Jiangsu Provincial People’s Government) [No. [2018] 87].