Cross-hedging strategies between CDS spreads and option volatility during crises

José Da Fonseca and Katrin Gottschalk

Journal of International Money and Finance, 2014, vol. 49, issue PB, 386-400

Abstract: This paper presents a joint analysis of the term structure of credit default swap (CDS) spreads and the implied volatility surface for five European countries from 2007 to 2012, a sample period covering both the Global Financial Crisis (GFC) and the European debt crisis. We analyze to which extent effective cross-hedges can be performed between the credit and equity derivatives markets during these two crises. We find that during a global crisis a breakdown of the relationship between credit risk and equity volatility may occur, jeopardizing any cross-hedging strategy, which happened during the GFC. This stands in sharp contrast to the more localized European debt crisis, during which this fundamental relationship was preserved despite turbulent market conditions for both the CDS and volatility markets.

Keywords: Credit default swap; Term structure; Implied volatility surface; Factor decomposition; Market linkages; Cross-hedging (search for similar items in EconPapers)
JEL-codes: C14 C58 G12 G13 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:49:y:2014:i:pb:p:386-400

DOI: 10.1016/j.jimonfin.2014.03.010

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