Tuesday, September 30, 2014

Return Connectedness in Credit Default Swap Markets

Credit default swaps (CDS) on private and sovereign debt have become one of the major investment vehicles for investors since early 2000s.  That is why we applied our connectedness analysis framework to CDS markets as well. More specifically, we study the return connectedness among credit default swaps for sovereign debt of a group of developed and emerging market economies for the period from January 2010 to July 2014.  We focus on return connectedness rather than volatility connectedness in CDS markets, because the daily returns in CDS markets measure the fear in sovereign bond markets.

The full-sample static connectedness graph depicts a very interesting picture.  Returns for CDS on developed and emerging market government bonds form two sub-networks.  There are 15 countries in the developed country network sub-graph.  As denoted by node colors most of the developed country sovereign debt CDS generate low return connectedness to others. Among the developed countries, Belgium and Italy had the highest connectedness to others, followed by Spain, France, Netherlands and Austria.  U.S. has very low return connectedness to others, which means that it is likely to be a net recipient of return shocks from others.  The Southern, Spain, Italy, and Portugal, and the Northern European countries, Sweden, Denmark, Finland and Norway, form two subgroups that have high pairwise connectedness among each other.

The second sub-network graph includes Central and Eastern European economies as well as the major emerging market economies.  Among the 24 countries in this group there are only two developed economies: Japan and Israel.  While having very weak ties with this group of countries, Japan has no pairwise connectedness to other developed economies. Similarly, being located in a politically volatile region Israel also has stronger connectedness with emerging market economies than developed economies of Europe and the North America.

South Africa, Russia and Turkey are located at the center of the emerging market group and they have the highest return connectedness  to others over the 2010-2014 period, as shown by scarlet red color of their nodes.  In the emerging market group, Slovakia, Croatia, Bulgaria, Kazakhstan and Poland are located closer to the developed country group, which indicates that they are generating connectedness to developed country groups more than other countries in the emerging market group.  From their location, we can contemplate that Turkey, South Africa and Russia have more significant return connectedness to other emerging market economies in the CDS markets.

Central and Eastern European countries are mostly (with the exception of Kazakhstan and Poland) located in the northern half of the emerging market sub-network graph.  Among these countries Croatia, Romania, Hungary, Poland, Kazakhstan and Bulgaria generate more return connectedness to others. Latin American countries are located in the southern of the emerging market sub-graph.   Among the Latin American countries Brazil, Mexico, Panama and Colombia have higher connectedness to others compared to Chile, Venezuela and Peru. 

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