## Sammanfattning

The price of a credit default swap (CDS) and the bond spread are two market

prices of risk. If the two markets price credit risk equally in the long

run, there exists an approximate non-arbitrage relation between the CDS

price and bond spread. The parity condition can be tested as an equilibrium

relation in the cointegrated vector autoregressive (VAR) model. Empirical

studies have found that the CDS price and bond spread of US and European

investment-grade firms are cointegrated for some but not all firms in the

sample. Theoretical explanations for rejecting cointegration between the CDS

price and bond spread are suggested in the literature. In this paper we

consider empirical issues with tests of cointegration between CDS prices and

bond spreads in the heteroskedastic VAR model. Strong persistence and very

high persistence in volatility are stylised features of cointegrated systems

of CDS prices and bond spreads. We show that tests of cointegration rank

have low power under such conditions. One result from the power analysis is

that obtaining high power requires more than 1000 observations, or more than

four years of daily observations. Besides, there is empirical support that

the distribution of the errors is heavy-tailed with infinite fourth moment.

The asymptotic and bootstrap tests are invalid if the errors are

heavy-tailed with infinite fourth moment. Monte Carlo simulations indicate

that the wild bootstrap (WB) test may be justified with heavy-tailed errors

which do not have finite fourth moment. We apply the WB test to daily

observations from 2010 to 2016 on the CDS price and bond spread of US and

European investment-grade firms. The WB test accepts cointegration for most

firms in the full sample period. The evidence for cointegration is weak in

sub-sample periods from 2010 to 2013 and 2013 to 2016. Restrictions implied

by the theory are rejected for the companies with the strongest evidence for

cointegration. Our empirical results only partially support equal pricing of

risk in the CDS market and bond market.

prices of risk. If the two markets price credit risk equally in the long

run, there exists an approximate non-arbitrage relation between the CDS

price and bond spread. The parity condition can be tested as an equilibrium

relation in the cointegrated vector autoregressive (VAR) model. Empirical

studies have found that the CDS price and bond spread of US and European

investment-grade firms are cointegrated for some but not all firms in the

sample. Theoretical explanations for rejecting cointegration between the CDS

price and bond spread are suggested in the literature. In this paper we

consider empirical issues with tests of cointegration between CDS prices and

bond spreads in the heteroskedastic VAR model. Strong persistence and very

high persistence in volatility are stylised features of cointegrated systems

of CDS prices and bond spreads. We show that tests of cointegration rank

have low power under such conditions. One result from the power analysis is

that obtaining high power requires more than 1000 observations, or more than

four years of daily observations. Besides, there is empirical support that

the distribution of the errors is heavy-tailed with infinite fourth moment.

The asymptotic and bootstrap tests are invalid if the errors are

heavy-tailed with infinite fourth moment. Monte Carlo simulations indicate

that the wild bootstrap (WB) test may be justified with heavy-tailed errors

which do not have finite fourth moment. We apply the WB test to daily

observations from 2010 to 2016 on the CDS price and bond spread of US and

European investment-grade firms. The WB test accepts cointegration for most

firms in the full sample period. The evidence for cointegration is weak in

sub-sample periods from 2010 to 2013 and 2013 to 2016. Restrictions implied

by the theory are rejected for the companies with the strongest evidence for

cointegration. Our empirical results only partially support equal pricing of

risk in the CDS market and bond market.

Originalspråk | Engelska |
---|---|

Titel på värdpublikation | 9th Nordic Econometric Meeting, May 24-27, 2017 in Tartu, Estonia |

Antal sidor | 32 |

Utgivningsdatum | 2017 |

Status | Publicerad - 2017 |

MoE-publikationstyp | A4 Artikel i en konferenspublikation |

Evenemang | 9th Nordic Econometric Meeting (NEM) - Tartu, Tartu, Estland Varaktighet: 24.05.2017 → 27.05.2017 Konferensnummer: 9 |

## Nyckelord

- 511 Nationalekonomi