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Default Clustering Risk Premium and its Cross-Market Asset Pricing Implications

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Abstract

This study examines the market-implied premiums for bearing default clustering risk by analyzing credit derivatives contracts on the CDX North American Investment Grade (CDX.NA.IG) portfolio between September 2005 and March 2021. Our approach involves constructing a time series of reference tranche rates exclusively derived by single-name CDS spreads. The default clustering risk premium (DCRP) is captured by comparing the original and reference tranche spreads, with the former exceeding the latter when investors require greater compensation for correlated defaults at the portfolio level. The fitted DCRP level significantly increased in response to the 2007-9 global financial crisis and remained relatively stable for a period, followed by a gradual decline beginning in 2016. Notably, the COVID-19 shock caused another sharp rise in the DCRP level. Our empirical analysis finds that the estimated DCRP has significant implications for asset pricing, particularly in affecting the investment opportunities available to U.S. stock investors during times of instability in the financial system.

Suggested Citation

  • Kiwoong Byun & Baeho Kim & Dong Hwan Oh, 2023. "Default Clustering Risk Premium and its Cross-Market Asset Pricing Implications," Finance and Economics Discussion Series 2023-055, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2023-55
    DOI: 10.17016/FEDS.2023.055
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    1. Dong Hwan Oh & Andrew J. Patton, 2018. "Time-Varying Systemic Risk: Evidence From a Dynamic Copula Model of CDS Spreads," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 36(2), pages 181-195, April.
    2. Joost Driessen, 2005. "Is Default Event Risk Priced in Corporate Bonds?," The Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 165-195.
    3. Peter Carr & Liuren Wu, 2011. "A Simple Robust Link Between American Puts and Credit Protection," The Review of Financial Studies, Society for Financial Studies, vol. 24(2), pages 473-505.
    4. Tse, Y K & Tsui, Albert K C, 2002. "A Multivariate Generalized Autoregressive Conditional Heteroscedasticity Model with Time-Varying Correlations," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 351-362, July.
    5. Chen, Ren-Raw & Cheng, Xiaolin & Fabozzi, Frank J. & Liu, Bo, 2008. "An Explicit, Multi-Factor Credit Default Swap Pricing Model with Correlated Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(1), pages 123-160, March.
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    More about this item

    Keywords

    Credit Default Swap (CDS); CDS Index (CDX); Reference Tranche Rate; Default Clustering Risk Premium;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • C40 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - General

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