Is Tail Risk Priced in Credit Default Swap Premia?

Christian Meine · Hendrik Supper · Gregor N. F. Weiß

36 citations0/0 files storedEuropean Finance Review

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Credit Risk and Financial Regulations Banking stability, regulation, efficiency Financial Risk and Volatility Modeling

Abstract

Abstract We show that the propensity of a bank to experience extreme co-movements in its credit default swap (CDS) premia together with the market is priced in the bank’s default swap spread during the financial crisis. We measure a bank’s CDS tail beta by estimating the upper tail dependence between its default swap spreads and a CDS market index. Our study shows that protection sellers receive a premium for bearing the risk of extreme upward co-movements in default risk. The economic significance of this effect is large yet limited to the recent financial crisis. Banks in the upper quintile of CDS tail beta have spreads that are on average 140 basis points higher than those of banks in the lower CDS tail beta quintile.

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References

1979Prospect Theory: An Analysis of Decision under Risk 1988Prospect theory: An analysis of decision under risk 1982Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation 1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1974ON THE PRICING OF CORPORATE DEBT: THE RISK STRUCTURE OF INTEREST RATES*1983Bank Runs, Deposit Insurance, and Liquidity 2002Dynamic Conditional Correlation 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]

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