Modelling the dependence structures of Australian iTraxx CDS index

Abstract

In contrast to market expectations, the correlation between credit default swap (CDS) spreads and their respective stock prices in Australia was found to be positive. The global financial crisis (GFC) affected the nonlinear association between the two asset classes with firms experiencing financial distress and stock prices plummeting. CDSs issuers reacted to such exogenous shocks by increasing their risk premiums on their spreads, reflecting the increased inherent risk. By splitting the data into pre- and post-GFC contexts and by employing the use of Archimedean copulas, we observe a negative co-movement in the post-GFC period. This finding is robust to several equity indices. Overall, such result is critical for investors engaging in arbitrageur activities.

Keywords:

• Archimedean copulas
• nonparametric estimates
• iTraxx CDS indices

JEL Classification:

• C02
• G19
• G23

Notes

¹ This contains the ASX top 20 stocks by way of Market Capitalization, and has a very high degree of liquidity and is suitable for investment by large global hedge funds. Hence, it was expected to trail very closely to the equally weighted index.

² The S&P/ASX 50 Index represents the ‘large-cap’ aspect of the Australian Stock Market. Eligible stocks are the 50 largest ASX listed by way of Market Capitalization. Hence, it was expected to trail very closely to the equally weighted index.

³ EW, ASX20 and ASX50.

⁴ As a robustness test, we also used September 2008 as another potential cut-off date. This was the month when the US Stock Exchange experienced one of its worst falls as Lehman Brothers, Bearn Stearns and a number of other organizations either defaulted or were bailed out by the US government.