Firm credit risk in normal times and during the crisis: are banks less risky?

Bank solvency was a major issue during the financial crisis of 2007–2009, but bank credit default swap (CDS) spreads were almost always below nonbank CDS spreads. What is the reason for this gap? Are banks perceived to be less risky? This study empirically decomposes CDS premia for 45 major banks and 167 large industrial firms from Europe and the US. It turns out that expected losses are usually somewhat lower for banks than for nonbanks, but expected losses contribute relatively little to the observed CDS premia. CDS spreads for banks and nonbanks differ mainly because market participants require a lower compensation for bearing bank credit risk. The quite persistent difference in the credit risk premia for banks and nonbanks disappears only temporarily during the crisis.     

Remittances and bond yield spreads in emerging market economies

This paper tests whether remittances reduce bond yield spreads in emerging market economies. Drawing upon instrumental variable techniques, our paper reveals that remittance inflows significantly reduce bond yield spreads. This result is robust to different specifications, alternative instrumentation techniques, additional control variables, and the use of credit default swap spreads in place of bond spreads. In addition, we find that the effect of remittances on spreads (i) is larger in (more) poorly developed financial systems, (ii) increases with the degree of trade openness, (iii) is larger in low fiscal space regimes, and (iv) is larger in nonremittance‐dependent countries. The paper concludes that policies that improve the measurement of remittance inflows and reduce their transfer costs or that enable countries to develop securitization of remittances and diaspora bonds could help emerging market economies to leverage remittances for international capital market access.     

Sovereign Default Risk and Recovery Rates: What Government Bond Markets Expect for Greece

Bond market data on sovereign bond yields is used to estimate sovereign default risk and the amount of the expected “hair‐cut” for Greece between 2008 and 2011. Using a structural pricing model that relies on compound option theory short‐term and long‐term default probabilities and their dependencies can be inferred. Thereby bond yield spreads for different maturities are integrated. In addition, a reduced form model is applied to infer the recovery rate expected by bond market participants. The paper shows that sovereign default risk and recovery rate dynamics reflect events that are important for Greece's repayment capacity.     

Effects of asset purchases and financial stability measures on term premia in the euro area

We study the effects of the announcements of ECB asset purchases and of financial stability measures in the euro area in the wake of the global financial crisis and the euro area sovereign debt crisis on 10-year government bond term premia in 11 euro area countries. We find that the term premia of euro area countries with higher sovereign risk, as measured by sovereign CDS spreads, decreased more in response to the announcements of asset purchases and financial stability measures. Term premia of countries with lowest sovereign risk either increased as in Germany, or were not significantly affected or fell slightly, as in the Netherlands and Finland.     

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

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.     

Testing for Regime Changes in Greek Sovereign Debt Crisis

This paper examines whether the efficiency market hypothesis for the Greek sovereign debt holds. As in Blanco et al. (2005) we test the theoretical equivalence of credit default swap (CDS) and spreads that dictates a CI relationship between the two. The main innovation of the present analysis is the use of a threshold vector error-correction (TVECM) model, thus allowing thresholds within the sample covering the period 1990 to 2010. Moreover, by employing this methodology we are able to evaluate the degree and dynamics of transaction costs resulting from various events due to external market imperfections but also domestic factors. The main hypothesis we test is to what extent spreads and CDS are indeed integrated that may result in an efficient and integrated segniorage capital market. Our findings support the gradual integration hypothesis. We find that spreads and CDS are cointegrated, though threshold effects are also revealed in terms of events that have impacted on markets.     

Rules and risk in the Euro area

We show that stronger fiscal rules in Euro area members reduce sovereign risk premia, in particular in times of market stress. Using a unique data set of rules-based fiscal governance in EU member states, we estimate a model of sovereign spreads that are determined by the probability of default in interaction with the level of risk aversion. The legal base of the rules and their enforcement mechanisms are the most important dimensions of rules-based fiscal governance.     

Do Market‐based Indicators Anticipate Rating Agencies? Evidence for International Banks

This paper analyses the ability of credit default swap (CDS) spreads, bond spreads and stock prices to anticipate the decisions of the main rating agencies, regarding the largest international banks. Conditional on negative rating events, all the three indicators show significant abnormal changes before both announcements of review and actual credit rating changes, but rating actions still seem to convey new information to the market. Results for positive rating events are less clear‐cut with the market indicators generally showing abnormal behaviours only in conjunction with the events. As for the predictive power of the financial indicators examined, the CDS market is particularly useful for negative events and stock prices for positive events. However, all indicators also send many false signals and are to be interpreted with care.     

Credit ratings and bond spreads of the GIIPS

We examine the relationship between credit ratings and bond yield spreads of peripheral countries in the euro area (Greece, Ireland, Italy, Portugal and Spain) for the period 1995–2014. Since 2012, bond spreads of those countries have come down very fast, whereas credit ratings have hardly changed. Our results suggest that credit rating agencies have become more cautious and have changed their approach to assess credit risk of sovereigns, and that the impact of sovereign credit risk ratings on sovereign bond spreads has changed.     

Sovereign Reputation and Yield Spreads: A Case Study on Retroactive Legislation

This paper uses recent legislation in Austria to establish a link between sovereign reputation and yield spreads. In 2009, Hypo Alpe Adria International, a bank previously co‐owned by the regional government of Carinthia, had been nationalized by Austria's central government in order to avoid a default triggering multi‐billion Euro local government guarantees. In 2015, special legislation retroactively introduced collective action clauses allowing a haircut on both the bonds and the guarantees while avoiding formal default. We document that legislative and administrative action designed to partly abrogate the guarantees resulted in a loss of reputation, leading to higher yield spreads for sovereign debt. Our analysis of covered bonds uncovers an increase in yield spreads on the secondary market and a deterioration of primary market conditions.     

European policy and markets: Did policy initiatives stem the sovereign debt crisis in the euro area?

We investigate how European policy initiatives influenced market assessments of sovereign default risk and banking sector fragility during the sovereign debt crisis in four adversely affected countries — Portugal, Ireland, Spain and Italy. We focus on three broad groups of policies: (a) ECB policy actions (monetary and financial support), (b) EU programs (financial and fiscal rules as well as financial support in crisis countries), and (c) domestic austerity programs. We measure immediate market impact effects: what policies changed risk perceptions, using CDS spreads on sovereign bonds and banks in this assessment. We employ dynamic panel and event study methodologies in the empirical work. We find that a number of programs initially stabilized sovereign and bank bond markets (e.g. Outright Monetary Transactions program), although announcement and implementation impacts on markets differed in some cases (e.g. second Covered Market Bond Program). Actions designed to shore up sovereign markets often lowered risk assessments in bank bond markets and policies designed to ensure safety and soundness of the European banking system in some cases significantly impacted sovereign debt markets. Finally, a number of policies designed to stabilize markets had surprisingly little immediate impact on either sovereign or bank bond market risk assessments.     

Risks of Latin America sovereign debts before and after the financial crisis

We investigate the financial determinants of the return and volatility of sovereign CDS spread from six major Latin American countries before and after the bankruptcy of Lehman Brothers. Other than CBOE VIX index, we also find that global factors including US Baa–Aaa default yield, TED spread and US Treasury rate all contribute to the changes in these sovereign CDS spread. Although global risk aversion (VIX) is a significant determinant of sovereign debt spread, in the years after the crisis, the emphasis has shifted towards short-term refinancing risk (TED). Furthermore, the risk of Greek sovereign debt crisis also transmitted Latin American CDS spreads immediately, but only in the post-Lehman sub-period. These findings provide implications for international bonds and credit derivatives trading strategies.     

Equity market information and credit risk signaling: A quantile cointegrating regression approach

Investigating linkages between credit and equity markets, we consider daily aggregate U.S. CDS spreads as well as well-chosen equity market and implied volatility indexes over ten years. We describe such robust (to spurious correlation) relationship with the quantile cointegrating regression approach. Such approach handles extreme quantiles/CDS values and their behavior with respect to the equity market's influence. Heteroskedastic patterns such as time-varying variance, but also autocorrelation, skewness and leptokurtosis are captured. Thus, the sensitivity of aggregate CDS spreads to equity market price and volatility channels is accurately measured across quantiles and spreads. Such quantile-dependent sensitivity exhibits asymmetric responses to equity market shocks. A sub-period analysis investigates potential regime shifts in estimated quantile cointegrating regressions. Quantile cointegrating coefficients vary over time and quantiles, and exhibit different magnitudes across sub-periods and spreads. Therefore, the relationship is unstable over time. We also propose a scenario analysis and risk signaling application for credit risk management prospects. Under specific risk levels, credit risky situations are described conditional on the equity market's information over time, and related expected aggregate CDS spreads are computed. Estimated conditional quantiles/CDS spreads act as credit alert triggers.     

Macroeconomic variables and the sovereign risk premia in EMU,non-EMU EU,and developed countries

This project studies and models key macroeconomic variables and their impact on sovereign risk premia across select European economies and developed countries. The sample is divided into three groups of countries: those in the European Monetary Union (EMU); the standalone economies outside the EMU but members of the broader European Union (EU); and other developed economies. The main subject of examination across all three groups is the impact of macroeconomic variables on sovereign borrowing costs. EU countries have experienced high financial stress and a rapid rise in the credit default swaps (CDS) spreads during the EMU debt crisis. A nonlinear vector smooth transition autoregressive model is applied to investigate such a regime change in the finance-output link using sovereign CDS and industrial production index. The paper finds that regime-switching takes place rather suddenly in most EMU countries. The study concludes that due to the potential spillover effects in the EU as a whole, the individual country macroeconomic indicators were less reflected in the financial stress and spillover and contagion effects became dominant.     

The relationship between risk-neutral and actual default probabilities: the credit risk premium

The study investigates empirically the relationship between the risk-neutral measure Q and the real-world measure P. We study the ratio between the risk-neutral and actual default intensities, which we call the coverage ratio or the relative credit risk premium. Actual default intensities are derived from rating agencies annual transition matrices, while risk-neutral default intensities are bootstrapped from CDS quotes of European corporates. We quantify the average risk premium and its changes over time. Compared to related literature, special attention is given to the effects of the recent financial and European sovereign crises. We find that average credit risk premia rose substantially and that post-crisis levels are still higher than those observed before the financial crisis. This observation is especially true for high-quality debt and if it persists, it will have an impact on corporates funding costs. The quantification and revision of risk premia contributes to the discussion of the credit spread puzzle and could give extra insights in valuation models that start from real-world estimates. Our work is furthermore important in the context of state aid assessment. The real economic value (REV) methodology, applied by the European Commission to evaluate impaired portfolios, is based on a long-term average risk premium.     

Modelling the dependence structures of Australian iTraxx CDS index

In contrast to market expectations, the correlation between credit default swap (CDS) spreads and their respective stock prices in Australia was found to be positive. The global financial crisis (GFC) affected the nonlinear association between the two asset classes with firms experiencing financial distress and stock prices plummeting. CDSs issuers reacted to such exogenous shocks by increasing their risk premiums on their spreads, reflecting the increased inherent risk. By splitting the data into pre- and post-GFC contexts and by employing the use of Archimedean copulas, we observe a negative co-movement in the post-GFC period. This finding is robust to several equity indices. Overall, such result is critical for investors engaging in arbitrageur activities.     

Asymmetric determinants of CDS spreads: U.S. industry-level evidence through the NARDL approach

This paper investigates the presence of asymmetries in the short- and long-run relationships between the 5-year CDS index spreads at the U.S. industry level and a set of major macroeconomic and financial variables, namely the corresponding industry stock indices, the VIX index, the 5-year Treasury bond yield and the crude oil price, using the NARDL approach. The empirical results provide significant evidence of both short-run and long-run asymmetries in the linkage between ten industry CDS spreads and the potential driving factors common for all industries, confirming the importance of asymmetric nonlinearity in this context. It is also shown that the industry equity prices, the VIX, the 5-year Treasury bond rate and, to a lesser extent, the crude oil price constitute important asymmetric determinants of these U.S. industry CDS spreads. The findings of this study have relevant implications for investors, speculators, arbitrageurs and policy makers interested in credit risk at the industry level.     

Bond risk premia, macroeconomic fundamentals and the exchange rate

We propose a two-country no-arbitrage term-structure model to analyze the joint dynamics of bond yields, macroeconomic variables and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries and how the exchange rate is influenced by interest rates, macro-economic variables and time-varying bond risk premia.Estimating the model with US and German data, we find that time-varying bond risk premia account for a significant portion of the variability of the exchange rate: apparently, a currency tends to appreciate when investors expect large capital gains on long-term bonds denominated in that currency. A number of other novel empirical findings emerge.     

Bond risk premia,macroeconomic fundamentals and the exchange rate

We propose a two-country no-arbitrage term-structure model to analyze the joint dynamics of bond yields, macroeconomic variables and the exchange rate. The model allows to understand how exogenous shocks to the exchange rate affect the yield curves, how bond yields co-move in different countries and how the exchange rate is influenced by interest rates, macro-economic variables and time-varying bond risk premia.Estimating the model with US and German data, we find that time-varying bond risk premia account for a significant portion of the variability of the exchange rate: apparently, a currency tends to appreciate when investors expect large capital gains on long-term bonds denominated in that currency. A number of other novel empirical findings emerge.     

Evaluating sovereign risk spillovers on domestic banks during the European debt crisis

Using a Markov-switching model with time-varying probabilities, spillovers from sovereign to domestic bank CDS spreads during the European debt crisis for a set of 14 European countries and 30 European banks are investigated. Our model is able to capture how the increased sovereign risk observed between 2010 and 2013 throughout Europe has impacted i) the probability that banks fall into a crisis regime and ii) the probability that banks stay in the crisis regime. The latter state is characterized by a high volatility and large positive returns of CDS spreads. Different regime-dependent indicators have been computed to assess heterogeneity within the region. The evidence indicates that the intensification of sovereign risk observed during the European debt crisis has positively and significantly driven the regime shifts in volatility of the bank CDS spreads due to increased risk aversion. The results show that the increase in sovereign credit risk seems to have generated second-round effects for some banks that have experienced a deterioration in their funding conditions due to a rise in the domestic sovereign default risk. Overall, our results suggest that sovereign CDS spreads can be considered good forewarning indicators for predicting the evolution of bank CDS spreads. We also find that the effects differ depending on the country and the financial institution. This result suggests that banks are heterogeneously exposed to sovereign credit risk within the same country. One argument relates to the size of these financial institutions and the domestic exposure to sovereign debt.