A Joint Analysis of the Term Structure of Credit Default Swap Spreads and the Implied Volatility Surface

Authors

  • José Da Fonseca,

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    • José Da Fonseca and Katrin Gottschalk are Senior Lecturers at the Department of Finance, Auckland University of Technology, New Zealand
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  • Katrin Gottschalk

    1. José Da Fonseca and Katrin Gottschalk are Senior Lecturers at the Department of Finance, Auckland University of Technology, New Zealand
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  • Comments from Yuen Jung Park and participants at the 18th International Conference on Computing in Economics and Finance (CEF 2012) in Prague and the 8th Annual Conference of the Asia-Pacific Association of Derivatives (APAD 2012) in Busan are gratefully acknowledged.

Correspondence author, Department of Finance, Business School, Auckland University of Technology, Private Bag 92006, 1142 Auckland, New Zealand. Tel: +64-9-9219999 ext. 5063, Fax: +64-9-9219940, e-mail: jose.dafonseca@aut.ac.nz

Abstract

This study analyzes the co-movements of the term structure of credit default swap (CDS) spreads and the implied volatility surface by performing a factor decomposition for both dynamics. In our joint analysis we compute the information flow between the credit and volatility factors, examine their contemporaneous interactions, and assess the effectiveness of cross-hedges. Using options and CDS data for U.S. and European indices, the credit market is found to be the main contributor to overall market innovations. Our methodology is parsimonious and captures the intrinsic relationships between both markets. The empirical study highlights cross-market linkages during the Global Financial Crisis. Factors with small associated eigenvalues can be of tremendous importance for effective cross-hedging. © 2013 Wiley Periodicals, Inc. Jrl Fut Mark

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