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A Linear and Nonlinear Review of the Arbitrage-Free Parity Theory for the CDS and Bond Markets

  • Kitty MoloneyEmail author
  • Srinivas Raghavendra
Conference paper
Part of the Springer Proceedings in Mathematics & Statistics book series (PROMS, volume 19)

Abstract

The arbitrage-free parity theory states that there is equivalence between credit default swap (CDS) spreads and bond market spreads in equilibrium. We show that the testing of this theory through the application of linear Gaussian bivariate modeling will lead to misleading results for CDS and bond spreads, and that linear stochastic modeling is not appropriate for CDS spreads. We propose the nonlinear and nonparametric dynamic tools of cross recurrence plots and cross recurrence plot measures to evaluate the arbitrage-free parity theory. We conclude that convergence is nonmean reverting and varying through time and across countries. This finding refutes the arbitrage-free parity theory. We also conclude that the probability to arbitrage will be affected by country and time-specific factors such as the expectation for country-specific government intervention. We propose that this methodology could be used by policy markets to supervise arbitrage activity and to influence policy making.

Keywords

Credit Default Swap Bond Market Euro Zone Credit Default Swap Spread Sovereign Bond 
These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.

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Copyright information

© Springer Science+Business Media New York 2012

Authors and Affiliations

  1. 1.J.E. Cairnes School of Business and EconomicsNational University of Ireland GalwayGalwayIreland

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