Modeling the dependence structure between default risk premium, equity return volatility and the jump risk: Evidence from a financial crisis

Nader Naifar

Economic Modelling, 2012, vol. 29, issue 2, 119-131

Abstract: This paper investigates the dependence structure between default risk premium, equity return volatility and jump risk in the equity market before and during the subprime crisis. Using iTraxx CDS index spreads from Japanese and Australian markets, the paper models the different relationships that can exist in different ranges of behavior. We consider several Archimedean copula models with different tail dependence structures, namely, Gumbel, Clayton, Frank, AMH and Joe copulas. Although the dramatic change in the levels of the iTraxx CDS index, we find strong evidence that the dependence structure between CDS and stock market conditions is asymmetric and orienting toward the upper side. In addition, we find that the Japanese CDS market is more sensitive to the stock return volatility than the jump risk and the magnitude of this sensitivity is related to the market circumstances. However, Australian CDS market is more sensitive to the jump risk than stock return volatility before and during the financial crisis. This result has important implications for both global financial stability and default risk management. Specifically, the heterogeneity of markets, coupled with the diversity in the risk exposures cause the default risk premium and equity markets to exhibit different levels of sensitivity.

Keywords: Nonlinear dynamics; Archimedean copulas; Subprime crisis; Credit default swap; iTraxx CDS index; Equity return volatility; Kurtosis of equity return distribution (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (18)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:29:y:2012:i:2:p:119-131

DOI: 10.1016/j.econmod.2011.08.026

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