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Jul 7

Necessity to Explain CDS with A Regime Switching Model

Posted by abiao at 09:56 | Code » R/Splus | Comments(4) | Reads(7663)
Examining the determinants of credit default swap (CDS) spreads is a hot topic, CDS spread has displayed siginificant regime switching behaviour since the break of credit crisis, which can be seen from the old graph in the post Credit Default Spread and Historical Volatility
cds spread volatility

There are sound reasons to believe that CDS spreads keep high in the period of turbulence while stay stably low during most of quiet periods. To investigate if there is possible regime switch phenomenon, I run a three year rolling panel regression using CDSs of over 250 reference entities on several widely accepted explanatory variables including: leverage, volatility, treasury yield and the spread of three month Libor and repo rates, where the last variable is used to proxy liquidity risk. The coefficients for each variable is plotted below
cds spread panel regression results
the coefficients of leverage and treasury yields are changing but without clear regime pattern, on the contrary, the volatility, especially the liquidity effects are suggesting there may exist regime switching and the necessity to employ a Markov regime switch model to explain CDS spreads.

PS: a matlab markov regime switching package can be found here; the panel regression is done with the R package PLM at http://cran.r-project.org/web/packages/plm/vignettes/plm.pdf


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SellSideQuant
Very interesting - have you written this up? Would be great if you post it.
Yes, I will present the paper at the 24th Australasian Finance & Banking conference in December, and the paper was submitted to a journal and is waiting for result. I will post it after the conference. Thanks for your interest.
Hi Abiao,
What's the rationale to use Libor - Repo as a proxy for liquidity?
Hi Ting, I admit I should use a more direct proxy for CDS liquidity, Libor-Repo spread is used as a proxy for funding liquidity of financial market, when the spread is high, it is difficult to borrow money to trade an asset, which impacts liquidity as a result.
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