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The co-integration of CDS and bonds in time-varying volatility dynamics: do credit risk swaps lower bond risks?

Author

Listed:
  • Li Leon

    (Waikato Management School, University of Waikato, School of Accounting, Finance and Economics, Hamilton, New Zealand)

  • Scrimgeour Frank

    (Waikato Management School, University of Waikato, School of Accounting, Finance and Economics, Hamilton, New Zealand)

Abstract

This study analyzes the co-integration relationship between sovereign bonds and credit default swaps (CDS) and then examines the impact of CDS-bond deviation from the relationship on market volatility using the Markov-switching approach. Our empirical sample consists of the daily CDS premium and bond yield spread obtained with the DataStream database for the period from 2008 to 2014. Our empirical results show that the absolute value of the CDS-bond deviation is positively related to the probability of a high volatility regime and negatively related to the probability of a low volatility regime. This result implies a positive association between the CDS-bond deviation and the volatility in the CDS-bond market. Our findings are consistent across mature-market and emerging-market countries. Moreover, the evidence we uncover suggests that the practice of managing default risk of bonds via the use of CDS may increase the interest rate risk of the bond, which implies both wins and woes from the introduction of CDS, particularly for mature-market countries.

Suggested Citation

  • Li Leon & Scrimgeour Frank, 2022. "The co-integration of CDS and bonds in time-varying volatility dynamics: do credit risk swaps lower bond risks?," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 26(3), pages 475-497, June.
    • Handle: RePEc:bpj:sndecm:v:26:y:2022:i:3:p:475-497:n:8
    DOI: 10.1515/snde-2019-0141
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    More about this item

    Keywords

    CDS; Markov-switching model; Sovereign bonds; VECM; volatility;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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