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A Covariate Residual-Based Cointegration Test Applied to the CDS-Bond Basis

Author

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  • Game Aaron

    (Quantitative Risk Management, Governors of the Federal Reserve System, Washington, DC, United States)

  • Wu Jason

    (Board of Governors of the Federal Reserve System, Washington, DC, United States)

Abstract

This paper proposes a residual-based cointegration test with improved power. Based on the idea of Hansen (1995) and Elliot and Jansson (2003) in the unit root testing case, stationary covariates are used to improve the power of the residual-based augmented Dickey–Fuller (ADF) test. The asymptotic null distribution contains difficulty to estimate nuisance parameters for which there is no obvious method of estimation; therefore, we propose a bootstrap methodology to obtain test critical values. Local-to-unity asymptotics and Monte Carlo simulations are used to evaluate the power of the test in large and small samples, respectively. These exercises show that the addition of covariates increases power relative to the ADF and Johansen tests, and that the power depends on the long-run correlation between the covariates and the cointegration candidates. The new test is used to test for cointegration between Credit Default Swap (CDS) and corporate bond spreads for a panel of US firms during the 2007–2009 financial crisis. The new test finds stronger evidence for cointegration between the two spreads for more firms, relative to ADF and Johansen tests.

Suggested Citation

  • Game Aaron & Wu Jason, 2013. "A Covariate Residual-Based Cointegration Test Applied to the CDS-Bond Basis," Journal of Time Series Econometrics, De Gruyter, vol. 5(2), pages 163-192, April.
    • Handle: RePEc:bpj:jtsmet:v:5:y:2013:i:2:p:163-192:n:2
    DOI: 10.1515/jtse-2012-0020
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    References listed on IDEAS

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    Cited by:

    1. Lahiani, Amine & Hammoudeh, Shawkat & Gupta, Rangan, 2016. "Linkages between financial sector CDS spreads and macroeconomic influence in a nonlinear setting," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 443-456.

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