The dependence structure in credit risk between money and derivatives markets: A time-varying conditional copula approach

Abstract

Purpose

The purpose of this paper is to examine the dynamic dependence structure in credit risk between the money market and the derivatives market during 2004-2009. The authors use the TED spread to measure credit risk in the money market and CDS index spread for the derivatives market.

Design/methodology/approach

The dependence structure is measured by a time-varying Gaussian copula. A copula is a function that joins one-dimensional distribution functions together to form multivariate distribution functions. The copula contains all the information on the dependence structure of the random variables while also removing the linear correlation restriction. Therefore, provides a straightforward way of modelling non-linear and non-normal joint distributions.

Findings

The results show that the correlation between these two markets while fluctuating with a general upward trend prior to 2007 exhibited a noticeably higher correlation after 2007. This points to the evidence of credit contagion during the crisis. Three different phases are identified for the crisis period which sheds light on the nature of contagion mechanisms in financial markets. The correlation of the two spreads fell in early 2009, although remained higher than the pre-crisis level. This is partly due to policy intervention that lowered the TED spread while the CDS spread remained higher due to the Eurozone sovereign debt crisis.

Originality/value

The paper examines the relationship between the TED and CDS spreads which measure credit risk in an economy. This paper contributes to the literature on dynamic co-movement, contagion effects and risk linkages.

Citation

Wu, W. and G. McMillan, D. (2014), "The dependence structure in credit risk between money and derivatives markets: A time-varying conditional copula approach", Managerial Finance, Vol. 40 No. 8, pp. 758-769. https://doi.org/10.1108/MF-07-2013-0184