An empirical analysis of the dynamic dependences in the European Corporate credit markets : bonds vs. credit derivatives

Abstract

In this paper we provide new evidence on the determinants of credit spread returns and their dynamic dependences in three European corporate credit markets: the Bond market (cash market), the Credit Default Swap (CDS) market (derivatives market), and the Asset Swap Package (ASP) market (with properties of both derivatives and cash markets). Using daily data from 2005 to 2009, we find that credit spread returns are primarily driven by innovations and to a lower extent by changes in the expected loss component, the risk premium component, the liquidity premium component and the inertial component whose relative importance changes over time. The intra-market dependence during the current crisis decreases for bonds and ASP innovations but increases slightly for CDS. ASP and bond innovations are closely related, suggesting that the cash component dominates the ASP innovations’ behavior. On the other hand CDS’s innovations are unrelated with both the bonds’ and the ASP’s innovations, suggesting that the derivatives element in the ASP contract (due to the implicit interest rate swap) is essentially unrelated with the innovations in the pure credit derivative contract (CDS).