IDEAS home Printed from https://ideas.repec.org/p/fip/fedgfe/2011-18.html
   My bibliography  Save this paper

Cointegration test with stationary covariates and the CDS-bond basis during the financial crisis

Author

Listed:
  • Aaron L. Game
  • Jason J. Wu

Abstract

This paper proposes a residual based cointegration test with improved power. Based on the idea of Hansen (1995) and Elliott & 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 difficult 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 U.S. 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

  • Aaron L. Game & Jason J. Wu, 2011. "Cointegration test with stationary covariates and the CDS-bond basis during the financial crisis," Finance and Economics Discussion Series 2011-18, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2011-18
    as

    Download full text from publisher

    File URL: http://www.federalreserve.gov/pubs/feds/2011/201118/201118abs.html
    Download Restriction: no
    File URL: http://www.federalreserve.gov/pubs/feds/2011/201118/201118pap.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Jan De Wit, 2006. "Exploring the CDS-Bond Basis," Working Paper Research 104, National Bank of Belgium.
    2. Didier Cossin & Tomas Hricko & Daniel Aunon-Nerin & Zhijiang Huang, 2002. "Exploring for the Determinants of Credit Risk in Credit Default Swap Transaction Data: Is Fixed-Income Markets’ Information Suffcient to Evaluate Credit Risk?," FAME Research Paper Series rp65, International Center for Financial Asset Management and Engineering.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. 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.
    2. Virginie Coudert & Mathieu Gex, 2010. "The Credit Default Swap Market and the Settlement of Large Defaults," International Economics, CEPII research center, issue 123, pages 91-120.
    3. Trapp, Monika, 2009. "Trading the bond-CDS basis: The role of credit risk and liquidity," CFR Working Papers 09-16, University of Cologne, Centre for Financial Research (CFR).
    4. Virginie Coudert & Mathieu Gex, 2010. "Le règlement des défauts sur le marché des credit default swaps : le cas de Lehman Brothers," Revue d'Économie Financière, Programme National Persée, vol. 97(2), pages 15-34.
    5. Sergio Mayordomo & Juan Ignacio Peña & Juan Romo, 2011. "A New Test of Statistical Arbitrage with Applications to Credit Derivatives Markets," CNMV Working Papers CNMV Working Papers no. 4, CNMV- Spanish Securities Markets Commission - Research and Statistics Department.
    6. Giorgia Palladini & Richard Portes, 2011. "Sovereign CDS and Bond Pricing Dynamics in the Euro-area," NBER Working Papers 17586, National Bureau of Economic Research, Inc.
    7. Mayordomo, Sergio, 2009. "Are There Arbitrage Opportunities in Credit Derivatives Markets? A New Test and an Application to the Case of CDS and ASPs," DEE - Working Papers. Business Economics. WB wb096303, Universidad Carlos III de Madrid. Departamento de Economía de la Empresa.
    8. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
    9. Feixue Gong & Gregory Phelan, 2021. "Collateral Constraints, Tranching, and Price Bases," Department of Economics Working Papers 2021-07, Department of Economics, Williams College.
    10. Qing Bai & Lu Zhu, 2018. "The Effects of Industry Specific and Local Economic Factors on Credit Default Swap Spreads: Evidence from REITs," Journal of Financial Services Research, Springer;Western Finance Association, vol. 54(3), pages 293-321, December.
    11. Gregor Dorfleitner & Paul Schneider & Tanja Veža, 2011. "Flexing the default barrier," Quantitative Finance, Taylor & Francis Journals, vol. 11(12), pages 1729-1743.
    12. Shi, Yukun & Stasinakis, Charalampos & Xu, Yaofei & Yan, Cheng, 2022. "Market co-movement between credit default swap curves and option volatility surfaces," International Review of Financial Analysis, Elsevier, vol. 82(C).
    13. Lamia Bekkour & Thorsten Lehnert & Maria Chiara Amadori, 2011. "The Relative Informational Efficiency of Stocks, Options and Credit Default Swaps," LSF Research Working Paper Series 11-13, Luxembourg School of Finance, University of Luxembourg.
    14. Virginie Coudert & Mathieu Gex, 2013. "The Interactions between the Credit Default Swap and the Bond Markets in Financial Turmoil," Review of International Economics, Wiley Blackwell, vol. 21(3), pages 492-505, August.
    15. R. Pianeti & R. Giacometti, 2015. "Estimating the probability of multiple EU sovereign defaults using CDS and bond data," Quantitative Finance, Taylor & Francis Journals, vol. 15(1), pages 61-78, January.
    16. Hervé Alexandre & François Guillemin & Catherine Refait-Alexandre, 2015. "Downgrades of sovereign credit ratings and impact on banks CDS spread: does disclosure by banks improve stability?," Post-Print hal-01622782, HAL.
    17. Enrico Laghi & Michele Di Marcantonio & Eugenio D'Amico, 2014. "Estimating credit default swap spreads using accounting data, market quotes and credit ratings: the European Banks Case," FINANCIAL REPORTING, FrancoAngeli Editore, vol. 2014(2-3-4), pages 59-81.
    18. Davor Kunovac & Rafael Ravnik, 2017. "Are Sovereign Credit Ratings Overrated?," Comparative Economic Studies, Palgrave Macmillan;Association for Comparative Economic Studies, vol. 59(2), pages 210-242, June.
    19. Roberto Blanco & Simon Brennan & Ian W Marsh, 2004. "An empirical analysis of the dynamic relationship between investment-grade bonds and credit default swaps," Bank of England working papers 211, Bank of England.
    20. Feixue Gong & Gregory Phelan, 2023. "Collateral constraints, tranching, and price bases," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(2), pages 317-340, February.

    More about this item

    Keywords

    Swaps (Finance); Corporate bonds; Econometric models;
    All these keywords.

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedgfe:2011-18. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Ryan Wolfslayer ; Keisha Fournillier (email available below). General contact details of provider: https://edirc.repec.org/data/frbgvus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.