Abstract
This study examines migration and cascading of credit default swaps (CDS) risks among four oil-related sectors -autos, chemical, oil and natural gas production, and utility—in two models. Model 1 encompasses fundamental variables, and Model 2 includes market risks. The key finding of the study suggests that replacing the two financial fundamental variables (the 10-year Treasury bond rate and the S&P 500 index) of Model 1 with the two market risk variables (the S&P VIX and the Oil VIX) of Model 2 reduce the long- and short-run risk migration and cascading in the second model for both the full sample and the subperiod. The CDS and VIX indices both reflect fear and risk on their own. Among the four oil-related CDS spreads, the chemical and auto spreads are the most responsive to the other credit and market risks and the fundamentals in the long-run, while those of utility and oil and natural gas sectors are not responsive. The recent quantitative easing in the United States adds to spikes in the levels of the chemical CDS and the S&P 500 index in Model 1, and to the S&P VIX and default risk spread in Model 2. Implications for model builders and policy makers are also discussed.
Corresponding author. This paper was written while the second author (R. Sari) was a visiting professor at Middle East Technical University-Northern Cyprus Campus.
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Notes
- 1.
Each volatility index series has a given number of reference entities at a fixed coupon. The coupon is determined prior to the onset of each index series, and is the current spread of the underlying reference entities that equate the value of the index to par value (100Â %) at the time of calculation. The levels of the indices are calculated at the end of each business day at around 5:15Â pm.
- 2.
The BAA rate has more default risk than AAA which is almost close to zero default.
- 3.
We will not report the results for the Johansen-Juselius approach due to the lack of space. Those results are available from the authors.
- 4.
The pairs trade or pair trading is a market neutral trading strategy which enables traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. One pairs trade would be to short the outperforming asset and to long the underperforming one, betting that the “spread” between the two assets would eventually converge.
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Hammoudeh, S., Sari, R. (2014). Forcing Variables in the Dynamics of Risk Spillovers in Oil-Related CDS Sectors, Equity, Bond and Oil Markets and Volatility Market Risks. In: Ramos, S., Veiga, H. (eds) The Interrelationship Between Financial and Energy Markets. Lecture Notes in Energy, vol 54. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-55382-0_5
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