Dynamic linkages among cross-currency swap markets under stress

Abstract

This article examines the impacts of the European sovereign debt crisis on the Dynamic Conditional Correlation (DCC) between three European currencies (EUR, CHF and GBP) and the US dollar for 1-year maturities. We found that the correlation between each pair of the swap prices significantly fluctuated over time and exhibited a higher co-movement during the crisis period, suggesting a higher degree of market integration. Importantly, applying a linear regression framework with a crisis dummy variable to the derived DCC, we find evidence of spillover effects of the sovereign debt turbulence to the cross-currency swap markets, as reflected in the increased co-movement between the EUR/USD and CHF/USD swap prices.

Keywords:

• cross-currency swaps
• European sovereign debt crisis
• dynamic conditional correlation
• EGARCH

JEL Classification:

• C50
• F30
• G15

Notes

¹ See Nelson (1991) for the EGARCH model. The lag orders for both AR models in Equation 1(1) and EGARCH models in Equation 2(2) are assumed unity for parsimonious reasons.

² 16 December 2009 was chosen because Standard & Poor's cut Greece's credit rating from A1– to BBB+ on that day, triggering prominent concerns over the country's structural sovereign debt problems.

³ In Datastream, the cross-currency swap prices are available only from 11 June 2008.

⁴ The unit root test results are available upon request.