The Co‐Movement of Credit Default Swap Spreads, Equity Returns and Volatility: Evidence from Asia‐Pacific Markets

• Author: José Da Fonseca,Katrin Gottschalk
• DOI: http://doi.org/10.1111/irfi.12237
• Published date: 01 September 2020
• Date: 01 September 2020

The Co-Movement of Credit Default

Swap Spreads, Equity Returns and

Volatility: Evidence from Asia-

Pacific Markets*

JOSÉ DAFONSECA

†,‡

AND KATRIN GOTTSCHALK

†

†

Department of Finance, Business School, Auckland University of Technology,

Auckland, New Zealand and

‡

PRISM Sorbonne EA 4101, Université Paris 1 Panthéon –Sorbonne, Paris, France

ABSTRACT

We provide a comprehensive analysis of the co-movement of credit default

swap (CDS), equity, and volatility markets in four Asia-Pacific countries at

firm and index level during the period 2007–2010. First, we examine lead–

lag relationships between CDS spread changes, equity returns, and changes

in volatility using a vector autoregressive model. At the firm level equity

returns lead changes in CDS spreads and realized volatility. However, at the

index level the intertemporal linkages between the three markets are less

clear-cut. Second, we apply the measures proposed by Diebold and Yilmaz

(2014) to an analysis of volatility spillovers among the CDS, equities, and

volatility asset classes. The results suggest that realized volatility (at firm

level) and implied volatility (at index level) are the main transmitters of

cross-market volatility spillovers. Third, we analyze the impact of various

structural factors and confirm the importance of realized volatility of equity

returns as a determinant of CDS spreads.

JEL Codes: G12; G13; C13

Accepted: 27 June 2018

I. INTRODUCTION

The relationship between credit risk, volatility, and equity returns was under-

lined in the seminal work of Merton (1974) and initiated a large stream of

research in subsequent decades. Nowadays, credit risk is conveniently extracted

* A previous version of this paper was circulated under the name “The Dynamics of Credit Default

Swap Spreads and Equity Volatility.”Comments from Offer-Moshe Shapir, Samer Saade, Milena

Tieves, and participants at the 2011 Auckland Finance Meeting, the economic research seminar at

the University of Auckland, the Asian Finance Association and Taiwan Finance Association 2012

Joint International Conference, the 2013 World Finance Conference, the 2015 World Finance &

Banking Symposium, and the 4th IFMA International Conference are gratefully acknowledged.

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:3, 2020: pp. 551–579

DOI: 10.1111/irfi.12237

from the credit default swap (CDS)

1

market, while realized volatility can be

measured using high-frequency equity return data, which have become widely

available. This enables researchers to overcome a common problem when deal-

ing with less well-developed financial markets: the lack of equity derivatives,

which are required for the estimation of implied volatility. The aim of this

study is to provide a robust assessment of the co-movement of CDS spreads,

equity returns, and volatility in a sample of Asia-Pacific countries. We analyze

the relationship between these key quantities with a vector autoregressive

(VAR) model and the spillover measures proposed by Diebold and Yilmaz

(2009, 2012, 2014). We also examine further determinants of CDS spreads

beyond equity returns and volatility.

Focusing on the three key quantities of interest (CDS spreads, equity returns,

and realized volatility), we study the joint dynamic of these variables in a VAR

model and, through a classical Granger causality test, examine which asset class

leads the others. The spillover measure recently proposed in Diebold and Yil-

maz (2009), which is based on the classical VAR model, enables us to quantify

the contribution of each variable (and by extension of the asset class it repre-

sents) to total market volatility spillovers. To round off the analysis, we identify

further determinants of credit risk beyond equity returns and volatility. For this

purpose, we regress CDS spreads on equity returns and volatility plus additional

firm-level and macro-economic explanatory variables. While a VAR system is

preferably applied to a small number of variables, a regression framework allows

us to extend the set of relevant structural factors considered. The combination

of these complementary approaches provides an exhaustive examination of the

fundamental relationship established by Merton (1974).

To the best of our knowledge, the VAR model and spillover measures have

never been applied to the triplet of variables CDS spread, equity returns, and

equity volatility for any market. While the determinants of credit spreads have

been analyzed for the US market, both at firm level and index level, the studies

focusing on the Asia-Pacific region are scarce, a fact that has sparked our inter-

est in these markets. Since for most Asia-Pacificfirms no options are available

(hence implied volatility is unavailable), only the use of realized volatility

makes this type of analysis possible at the firm level. In addition, we can study

the co-movement of credit, equity, and volatility markets at the aggregate level

since for most of these countries index data are available. A comparison

between market behavior at the firm level and the index level is pertinent to

reveal interesting effects related to liquidity and correlation.

1 A CDS is a credit derivative contract between two counterparties that essentially provides

insurance against the default of an underlying entity. In a CDS, the protection buyer makes

periodic payments to the protection seller until the occurrence of a credit event or the matu-

rity date of the contract, whichever comes first. The premium paid by the buyer is denoted as

an annualized spread in basis points and referred to as CDS spread. If a credit event (default)

occurs on the underlying financial instrument, the buyer is compensated for the loss incurred

as a result of the credit event, that is, the difference between the par value of the bond and its

market value after default.

© 2018 International Review of Finance Ltd. 2018552

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