Sovereign Risk, Cross-Currency Basis and Equity Markets: A Cross-Market Dynamic Interaction

Ibhagui, Oyakhilome (2020): Sovereign Risk, Cross-Currency Basis and Equity Markets: A Cross-Market Dynamic Interaction. Published in:

Abstract

To explore the propagation of shocks across markets, this paper examines the dynamic connections between three distinct markets: credit default swaps (CDS), equities, and cross-currency basis swaps (CCBS) of four major individual economies: Eurozone, UK, Australia, and Japan. We use CDS spreads, CCBS spreads and stock market returns to capture sovereign credit risk, dollar funding liquidity and stock market performance, respectively. Our results show there is a feedback mechanism connecting these markets, for most of these economies. We document that higher CDS spreads induce wider CCBS spreads and declines in stock market returns. We equally show that positive shocks to CCBS spreads lessen CDS spreads and enhance stock market returns. Finally, we show that positive shocks to the stock market are associated with lower CDS spreads and tighter CCBS spreads. These findings are supported by Granger-causality analysis and are robust across subperiods and empirical specifications. Underpinning the feedback mechanism is the role of CDS as an indicator of potential default on obligations in the financial markets.

• Item Type: MPRA Paper
• Language: English
• Keywords: Credit derivatives, dollar funding shortages, credit default and cross-currency swaps, equities performance, dynamic interdependence
• Subjects: F - International Economics > F3 - International Finance

References

1. Acharya, V. V., & Johnson, T. C. (2007). Insider trading in credit derivatives. Journal of Financial Economics, 84(1), 110-141.

2. Alter, A. & Schuler, Y.S. (2012) Credit spread interdependencies of European states and banks during the financial crisis. Journal of Banking and Finance, 36, 3444-3468.

3. Avdjiev, S., Du, W., Koch, C. & Shin, H. S. (2018): The dollar, bank leverage and the deviation from covered interest parity. BIS Working Paper, 592.

4. Barnes C. (2017). Cross Currency Swap Volumes. Clarus Financial Technology.

5. Blanco, R., Brennan, S., & Marsh, I. W. (2005). An empirical analysis of the dynamic relation between investment‐grade bonds and credit default swaps. The Journal of Finance, 60(5), 2255-2281.

6. Du, W., Tepper, A. & Verdelhan, A. (2018): Deviations from Covered Interest Rate Parity. Journal of Finance, 73, 915–957. doi: 10.1111/jofi.12620. Forte, S., & Pena, J. I. (2009). Credit spreads: An empirical analysis on the informational content of stocks, bonds, and CDS. Journal of Banking and Finance, 33, 2013-2025.

6. Fukuda, S. I., & Tanaka, M. (2017). Monetary policy and covered interest parity in the post GFC period: Evidence from the Australian dollar and the NZ dollar. Journal of International Money and Finance 74, 301-317.

7. Hull, J. C., & White, A. D. (2000). Valuing credit default swaps I: No counterparty default risk. The Journal of Derivatives, 8(1), 29-40.

8. Ibhagui, O, (2019). Interrelations Among Cross-Currency Basis Swap Spreads: Pre-and Post-Crisis Analysis, The Journal of Derivatives, 26(4), 89-112

9. Josifidis, K., Allegret, J. P., Gimet, C., and Pucar, E.M. (2014). Macroeconomic policy responses to financial crises in emerging European economies. Economic Modelling, 36, pp. 577-591.

10. Kębłowski P., Welfe A., (2012), A risk-driven approach to exchange-rate modelling. Economic Modelling 29, 1473-1482.

11. Koukouritakis, M., Papadopoulos, A. P. And Yannopoulos, A. (2015). Linkages between the Eurozone and the South-Eastern European countries: a global VAR analysis. Economic Modelling, 48, pp. 129–54

12. Kwan, S. (1996). Firm-specific Information and the Correlation Between Individual Stocks and Bonds. Journal of Financial Economics 40, 63-80.

13. Liew, V. K. S. (2004). Which lag length selection criteria should we employ? Economics bulletin, 3(33), 1-9.

14. Lintner, J. (1965). Security prices, risk, and maximal gains from diversification. The Journal of Finance, 20(4), 587-615.

15. Longstaff, F. A., Mithal, S. & Neis, E. (2003). The credit-default swap market: Is credit protection priced correctly? Unpublished manuscript, UCLA.

16. Longstaff, F., S. Mithal, & E. Neis. 2005. Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default-Swap Market. Journal of Finance 60, 2213–53.

17. Longstaff, F. A., J. Pan, L. H. Pedersen, and K. J. Singleton, 2011, How sovereign is sovereign credit risk? American Economic Journal: Macroeconomics 2, 75–103.

18. Norden, L., & Weber, M. (2009). The co-movement of credit default swap, bond and stock markets: An empirical analysis. European Financial Management 15, 529–62.

19. Pesaran, M. H. & Shin, Y. (1998) Generalized impulse response analysis in linear multivariate Models. Economics Letters, 58, 17-29.

20. Reboredo J. C., and Ugolini, A., (2019). Price connectedness between green bond and financial markets Economic Modelling, https://doi.org/10.1016/j.econmod.2019.09.004.

21. Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. The Journal of Finance, 19(3), 425-442.

22. Stulz R. (1995a). The cost of capital in internationally integrated markets: The case of Nestlé. European Financial Management, 1, March 11-22.

23. Stulz R. (1995b). Globalization of capital markets and the cost of capital: The case of Nestlé. Journal of Applied Corporate Finance, Fall, 30-38.

24. Trutwein, P. & Schiereck, D. (2011), The Fast and Furious – Stock Returns and CDS of Financial Institutions Under Stress. Journal of International Financial Markets, Institutions & Money, 21, 157-175.

25. Wen, Y., & Kinsella, J. (2013). Credit Default Swap- Pricing Theory, Real Data Analysis and Classroom Application Using Bloomberg Terminal. New York. Appendix