Applied Economics

ISSN: 0003-6846 (Print) 1466-4283 (Online) Journal homepage: http://www.tandfonline.com/loi/raec20

A joint analysis of market indexes in credit default

swap, volatility and stock markets

José Da Fonseca & Peiming Wang

To cite this article: José Da Fonseca & Peiming Wang (2015): A joint analysis of market
indexes in credit default swap, volatility and stock markets, Applied Economics, DOI:
10.1080/00036846.2015.1109036

To link to this article: http://dx.doi.org/10.1080/00036846.2015.1109036

Published online: 09 Nov 2015.

Submit your article to this journal

Article views: 24

View related articles

View Crossmark data

Full Terms & Conditions of access and use can be found at

http://www.tandfonline.com/action/journalInformation?journalCode=raec20

Download by: [Central Michigan University] Date: 12 December 2015, At: 00:57
 APPLIED ECONOMICS, 2015
http://dx.doi.org/10.1080/00036846.2015.1109036

A joint analysis of market indexes in credit default swap, volatility and

stock markets
José Da Fonseca and Peiming Wang
Department of Finance, Business School, Auckland University of Technology, Auckland, New Zealand

ABSTRACT KEYWORDS
This paper analyses the joint dynamics of the CDS, volatility and stock markets using both VAR Credit default swap;
and Markov regime-switching VAR models with market index data. It shows that the joint volatility; market linkages;
behaviour of the three markets is better characterized by the Markov model with two regimes Markov switching
corresponding to low- and high-volatile market conditions. The relationship between changes in JEL CLASSIFICATION
the market indexes under a regime is consistent with theory and persistent; the information C10; G12; G13
Downloaded by [Central Michigan University] at 00:57 12 December 2015

transmission process of shocks to the markets is similar for the two regimes with a more
important role for CDS shock; and the volatility in the money market is an important determinant
of regime-switching. The findings have practical implications, particularly for hedging strategies
with market indexes under different market conditions.

I. Introduction
The recent global financial crisis and the risks of
contagion that originated from derivative markets
have had a significant impact on equity markets.
As a consequence, fund managers need to pay
more attention to how financial markets change
their behaviour over time in order to provide inves-
tors with a performance in line with market bench-
marks and better manage investment risks. In this
study, we investigate the joint behaviour of the CDS,
VIX and equity markets with a focus on the
dynamics of changes in the market indexes. The
objectives of the study are to determine the mean,
volatility and correlation structures of the three mar-
ket indexes, analyse whether, and how these struc-
tures change over time, examine the information
transmission process of the three markets during
turbulent and quiescent periods, and identify the
factors that affect the structural changes in the
three markets.
There are two types of approaches relating equity/
asset volatility to credit default risk, namely, the
structural-form and intensity approaches. The for-
mer, introduced by Merton in his seminal work
Merton (1974), shows the important link between
asset volatility and credit default risk. This approach
on the pricing of credit risk can provide important
economic intuitions on what fundamental variables
explain the credit default spread. Hence, this
approach has been used in many theoretical and
empirical studies on analysing the interaction
between credit risk and volatility. In these studies
(e.g. Campbell and Taksler 2003), credit risk is typi-
cally measured by bond spread, while volatility is
computed using mean squared return on equity. As
an alternative to the structural-form approach, the
intensity or reduced-form approach goes back to
Duffie and Singleton (1999). This approach has the
advantage of being easier to implement as the state
variables are observable quantities.
The illiquidity of bond markets and the choice of
appropriate measure to proxy the risk-free rate
makes the bond spread (i.e. the difference between
the bond yield and the risk-free rate) not very sui-
table to analyse credit risk at daily or weekly fre-
quencies. Recently, due to the rapid development of
derivative markets, the interest has shifted to study-
ing credit risk indirectly by using CDS as a measure
of credit risk. In addition, the VIX index becomes a
more favoured choice for measure of equity volatility

CONTACT José Da Fonseca jose.dafonseca@aut.ac.nz

Comments from participants at the 2014 Portuguese Finance Network meeting held at Vilamoura, Portugal, are gratefully acknowledged. The usual caveat
applies.
© 2015 Taylor & Francis
 2 J. DA FONSECA AND P. WANG
because it is a forward-looking measure of volatility.
This leads to many studies investigating the relation-
ship between CDS and VIX index under univariate
regression setting where CDS is the response vari-
able and VIX index is an explanatory variable (e.g.
Benkert 2004; Byström 2008; Ericsson, Jacobs, and
Oviedo 2009; Zhang, Zhou, and Zhu 2009; Wang
and Yao 2014). To account for possible structural
changes in the CDS market over time, Alexander
and Kaeck (2008) apply a two-state Markov
regime-switching model to examine the impact of
VIX index on CDS in which either of the two
regimes is characterized by a univariate regression
with CDS as the dependent variable and VIX as one
Downloaded by [Central Michigan University] at 00:57 12 December 2015
of the explanatory variables. They also look into
factors that influence the regime-switching
mechanism.
There are several studies on joint analysis of three
different financial markets under VAR setting.1 For
instance, Norden and Weber (2009) employ a VAR
model to study the co-movement of the CDS, bonds
and stock markets with firm-level data. More
recently, Da Fonseca and Gottschalk (2011) and
Hyun, Kang, and Kim (2012) analyse the interaction
between the CDS, volatility and stock markets under
VAR setting. The former considers this relation at
the firm and index levels for major Asian markets,
whereas the latter focuses on the Korean market at
the index level. These studies show the interest of
examining joint dynamics of different markets to
understand how they interact (using either Diebold
and Yılmaz’s (2014) spillover measure or impulse
response analysis). Da Fonseca and Gottschalk
(2014) investigate the relationship between the entire
volatility surface and the term structure of CDS
spreads for the US market during the global financial
crisis and for several European markets during the
European debt crisis and how cross-hedging ratios
are affected. Nevertheless, VAR models assume that
the dynamic properties of different financial mar-
kets, particularly the covariance and correlation
between market indexes, remain the same during
turbulent and quiescent periods. This is inconsistent
with what happened around the recent global
1
There are also few other studies on joint analysis of two financial markets under bivariate setting. For instance, Caporin (2013) examines the dynamics for
two pairs: (1) equity index and CDS index, and (2) equity index and VIX index for the purpose of hedging equity risk with the use of either the CDS index or
the VIX index as instruments. Fenech, Vosgha, and Shafik (2014) use a copulas approach to analyse the joint dynamics of Australian CDS and equity market
indexes to investigate the impact of the global financial crisis on the association between the two market indexes. In Wang and Bhar (2014), a joint
analysis is performed for CDS spreads and equity returns for the US market using a VAR framework.
financial crisis during which there were sudden and
dramatic changes in the dynamic properties between
the equity, volatility and credit markets. Failing to
model possible shift in the dependence structure of
financial markets may result in incorrect inferences
about the relationship between different markets
and inferior strategies for investment and risk
management.
To overcome the shortcoming in VAR models, we
apply a Markov regime-switching VAR approach to
analyse the joint behaviour of the CDS, VIX and
stock markets. This approach characterizes two dif-
ferent dependent structures of the three markets
corresponding to turbulent and quiescent periods
by two different VAR specifications, and allows the
dependent structures to switch over time according
to a two-state Markov chain to capture the stylized
behaviour of the three markets, including heterosce-
dasticity and time-varying correlations. We also
examine factors that affect the regime-switching
between the two dependent structures in each of
the three phases of the recent global financial crisis:
before, during and after the crisis. In addition, we
study the information transmission process of
shocks to the three markets under either of the two
regimes using impulse response functions.
Univariate Markov regime-switching models have
been extensively used in many studies involving
stock market returns, return volatility forecasts and
CDS spread. Researchers employ these regime-
switching techniques to account for specific features
of financial time series such as the fat tails, volatility
clustering and mean reversion in stock prices (e.g.
Turner, Startz, and Nelson 1989; Cecchetti, Lam, and
Mark 1990; Schaller and Van Norden 1997), for
improving volatility forecasts (e.g. Klaassen 2002;
Haas, Mittnik, and Paolella 2004; Liu, Margaritis,
and Wang 2012) and for analysing the determinants
of CDS (e.g. Alexander and Kaeck 2008; Naifar
2012). This type of modelling is particularly plausi-
ble for describing the behaviour of market indexes in
an economy with regime shifts where the economic
mechanisms that trigger changes in the market
indexes over time and consequently the parameters

or even the structure of the market index regime
itself may change as the economic environment
changes. As for Markov regime-switching VAR
models, there are also a few applications in econom-
ics and finance studies including the analysis of
co-movements between stock prices and economic
output in Hamilton and Lin (1996), the joint analysis
of real GDP, price inflation and stock prices for a set
of countries (18 European countries) using a three-
regime GVAR in Binder and Gross (2013), the term
structure of interest rates in Sola and Driffill (1994),
the joint dynamics of the two volatility indexes: VIX
and MOVE in Zhou (2014)2; in Guo, Chen, and
Huang (2011) a Markov-switching model is applied
Downloaded by [Central Michigan University] at 00:57 12 December 2015
to the return on oil price, the return on stock index,
the CDS index and the return on housing price.
Note that the features and estimation of Markov
regime-switching VAR models are discussed in
great details in Krolzig (1997).
To preview our results, first, we find evidence of
the regime-switching in the joint dynamics of the
three markets over time as the Markov regime-
switching VAR model is more appropriate than the
VAR model. The mean, volatility and correlation
structures for the market indexes are different for
the two regimes representing the low and high vola-
tilities of the market indexes. Under either of the two
regimes, the CDS and VIX indexes are positively
correlated, while they are negatively correlated to
the equity index. Thus, the contemporaneous rela-
tionships between the CDS, VIX and equity market
indexes are consistent with Merton’s model. The
findings indicate the benefit of portfolio diversifica-
tion for investments in the three markets. Our find-
ings also show that hedge ratios are sensitive to
regime, which provides the basis for construction
of various hedging strategies including the use of
the CDS/VIX index as a hedge instrument for hed-
ging the equity risk under different market condi-
tions. Second, in terms of the impulse response
functions under a regime, the structure of the infor-
mation transmission process of shocks to the three
markets is quite similar for the two regimes. For
instantaneous impact, a CDS shock plays a more
important role in the transmission process because
any news affecting the CDS market also affects the
other two markets, but not vice versa. This suggests
2
MOVE stands for the Bank of America Merrill Lynch Treasury Option Volatility Estimate Index.
APPLIED ECONOMICS 3
that credit/default risk has more profound effect on
the three markets. In addition, the impact of shock is
relatively larger during turbulent periods than during
quiescent periods. Third, we find that the factors
related to the volatility of the money market such as
square of the LIBOR–OIS spread and square of the
SWAP–OIS spread have a significant impact on the
regime-switching mechanism throughout all the three
periods, while the impact of the factors related to the
CDS, VIX and equity markets on regime-switching is
significant only for the pre- and post-periods. More
specifically, the CDS factors are more important than
the factors related to the VIX and equity markets
before the crisis; and almost all the factors related to
the three markets become significant after the crisis.
This implies that after the global financial crisis the
linkage among the markets appears stronger.
The structure of the paper is as follows. In Section
II, we describe the data. In Section III, we present
the calibration results for a VAR model and a
Markov regime-switching VAR model. Section IV
contains the empirical results for the determinants
of the regime-switching mechanism and Section V
concludes the paper.
II. Data
In this study, we analyse the credit default swap
market using two CDS indexes: the CDX.NA.IG and
the CDX.NA.IG.HVOL. The former is the North
American investment grade credit default swap
index and is computed by averaging the CDS spreads
for 125 entities, and the latter is computed using the
30 constituents of the CDX.NA.IG with the widest
average CDS spreads over the past 90 days. For both
of them, we take the five-year CDS spread which is by
the far the most liquid. For the first index, the sample
covers the period 13 October 2004 to 8 February
2012, while for the other index it is slightly shorter
as the sample runs from 8 December 2004 to 8
February 2012. The data are sampled on weekly fre-
quency and we take the Wednesday as the observa-
tion day. Whenever a quote is not available for that
day then either go forward or backward by one day to
build an observation for a given week. Given a time
series for the credit default swap market, we take the
corresponding values for the VIX and the return for
 4 J. DA FONSECA AND P. WANG

the S&P500. Due to missing values, the samples built
using the CDX.NA.IG and CDX.NA.IG.HVOL may
differ slightly for a given period leading to small
discrepancies for some statistical values. The CDS
spreads are provided by Bloomberg, whereas the
VIX and S&P500 are extracted from Datastream.
As the samples contain periods during which the
market conditions might be quite different, we split
the whole sample period into three sub-sample per-
iods, namely pre-crisis, crisis and post-crisis, respec-
tively. The first one starts from the beginning the
considered sample to 25 July 2007 and is qualified as
the pre-crisis sub-sample. The second sub-sample
runs from 1 August 2007 to end of 2009 and con-
Downloaded by [Central Michigan University] at 00:57 12 December 2015
aggregates very different market behaviour; it is there-
fore of interest to carry out these simple descriptive
statistics for each sub-sample in order to exhibit the
great variability observed during that time frame.
For the pre-crisis sub-sample, the volatility is 13%
and the index return is positive at 0.19% (per week).
For the CDS spreads, the CDX.NA.IG is at 44 bps,
while the CDX.NA.IG.HVOL is at 94 bps. For the
crisis sub-sample, the CDS spreads, for both indexes
and the volatility increase substantially as they are
multiplied by a factor of 3. The CDX.NA.IG reaches
133 bps, the CDX.NA.IG.HVOL culminates at 315 bps
while the volatility is around 30%. Also of interest are
the standard deviations for these quantities that are

tains the global financial crisis. The last sub-sample
goes from 6 January 2010 to 8 February 2012 and is
the post-crisis sample. This partitioning is similar
with those made in the literature (see Bai and
Collin-Dufresne 2011).3
Table 1 reports the descriptive statistics for the
levels and the changes of the CDS spreads and the
volatility, as well as the stock index return. The mean
and the standard deviation are given for the whole
sample and for the three sub-samples. For the whole
sample, the CDS spread values are 90 bps and 192 bps
for the CDX.NA.IG and CDX.NA.IG.HVOL, respec-
tively. The higher level observed for the CDX.NA.IG.
HVOL is consistent with the definition of this index.
This index also shows a larger variability as the stan-
dard deviation is larger for both the level and the
change of the CDS spreads. On this whole sample,
the volatility has an average value of 21%, while the
index return appears to be positive at 0.03% (expressed
on a weekly basis). As mentioned earlier, our sample
much higher than for the previous sub-sample. This
huge variability can also be read on the standard
deviation of the changes for both the credit and vola-
tility markets. Lastly and consistently with Merton’s
theoretical framework, the mean index return appears
to be negative as the reported mean value confirms.
These statistical facts are just a numerical confirmation
of the events observed during the global financial
crisis. The last part of the sample, the third sub-sam-
ple, corresponds to the post-crisis period during which
the CDS and the volatility markets returned to lower
levels, while the index return was positive. It is of
interest to note that the mean values for the credit
and volatility markets stabilized at levels above the pre-
crisis values; this fact is better illustrated in Fig. 1(a) for
the CDX.NA.IG and in Fig. 1(b) for the CDX.NA.IG.
HVOL. It seems to us that the global financial crisis
introduced a structural change in the relation that ties
the credit market, the volatility market and the index
market. This fact will be later confirmed.

Table 1. Descriptive statistics for the CDX.NA.IG and the CDX.NA.IG.HVOL.

CDX.NA.IG CDX.NA.IG.HVOL
cds vol Rt ΔCDS ΔVOL cds vol Rt ΔCDS ΔVOL
Whole sample (13 Oct 2004–8 Feb 2012) (8 Dec 2004–8 Feb 2012)
Mean 90.53 21.56 0.04 0.11 0.01 192.12 21.86 0.03 0.27 0.01
Std. dev. 49.87 10.93 2.64 9.00 3.46 122.89 11.16 2.61 19.53 3.43
Pre-crisis (13 Oct 2004–25 Jul 2007) (8 Dec 2004–25 Jul 2007)
Mean 44.02 12.94 0.19 0.01 0.03 94.53 12.90 0.18 0.44 0.04
Std. dev. 8.11 1.94 1.26 2.57 1.37 18.29 1.98 1.25 6.19 1.42
Crisis (1 Aug 2007–30 Dec 2009) (1 Aug 2007–30 Dec 2009)
Mean 133.66 30.20 – 0.24 0.22 0.01 315.01 30.38 – 0.23 – 0.01 0.01
Std. dev. 52.16 12.55 3.64 14.48 4.68 128.13 12.69 3.43 30.92 4.42
Post-crisis (6 Jan 2010–8 Feb 2012) (6 Jan 2010–8 Feb 2012)
Mean 102.86 23.12 0.16 0.11 – 0.02 168.97 23.07 0.17 0.39 – 0.02
Std. dev. 16.92 6.59 2.64 5.83 3.78 38.51 6.58 2.75 11.59 3.90

3
To be more precise in Bai and Collin-Dufresne (2011), the authors have two crisis periods: the first one from 1 July 2007 to 31 August 2008 and the second
one from 1 September 2008 to 30 September 2009, this latter date being the end of their sample.
 APPLIED ECONOMICS 5

(a) Δxt ¼ a0 þ a1 Δxt1 þ
t ; (1)

CDS (CDX.NA.IG), VIX and S&P500 prices
1800 80 where Δxt ¼ ðΔCDSt ; ΔVOLt ; Rt ÞT with ΔCDSt ;
1600 70
1400 60
ΔVOLt , and Rt denoting change in the CDS index,
CDS, S&P500

1200 50 change in the VIX index and return in the S&P 500
1000
40

VIX
800 index for period t, respectively, and
30
600 T
400 20
t ¼ ð
1;t ;
2;t ;
3;t Þ ,Nð0; ΩÞ. For the CDS market
200 10
index, we consider two indexes: CDX.NA.IG and
0 0
CDX.NA.IG.HVOL. For either of the two CDS indexes,
10/2004
04/2005
10/2005
04/2006
10/2006
04/2007
10/2007
04/2008
10/2008
04/2009
10/2009
04/2010
10/2010
04/2011
10/2011
we obtain parameter estimates for the above model
CDS SP500 VIX with the data for the sample period from 13 October
2004 to 8 February 2012 for CDX.NA.IG and from 8
(b) December 2004 to 8 February 2012 for the CDX.NA.
CDS (CDX.NA.IG.HVOL), VIX and S&P500 prices
IG.HVOL, respectively. The estimation results are pro-
1800 80
vided in Tables 2 and 3.
Downloaded by [Central Michigan University] at 00:57 12 December 2015

1600 70
1400 60
1200
For the CDX.NA.IG, the estimated correlations
CDS, SP500

50
1000
40
between the variables are consistent with theory.
VIX
800
600 30 Specifically, the CDS spread is positively related to
400 20
200 10
0 0 Table 2. The estimation of the VAR model for CDX.NA.IG with
12/2004
06/2005
12/2005
06/2006
12/2006
06/2007
12/2007
06/2008
12/2008
06/2009
12/2009
06/2010
12/2010
06/2011
12/2011

the whole sample (13 Oct 2004–8 Feb 2012).

Panel A: Regression coefficients
CDS SP500 VIX
Const. ΔCDSt1 ΔVOLt1 Rt1
Figure 1. Data of CDX.NA.IG, CDX.NA.IG.HVOL, VIX and S&P 500 ΔCDSt 0.1939 –0.1535*** –0.5794** –1.4591***
ΔVOLt 0.0142 – 0.0533** –0.1251 0.0381
prices. (a) CDX.NA.IG: weekly observations from 13 October Rt 0.0426 0.0488*** 0.0316 0.0339
2004 to 8 February 2012. (b) CDX.NA.IG.HVOL: weekly observa-
Panel B: Covariance and correlation matrices
tions from 8 December 2004 to 8 February 2012.
Covariance Correlation
ΔCDSt ΔVOLt Rt ΔCDSt ΔVOLt Rt
A (two-regime) Markov-switching model will be ΔCDSt 76.33 13.31 –10.95 1 0.451 –0.479
ΔVOLt 13.31 11.39 –7.23 0.451 1 –0.819
estimated on the above-mentioned data and as a result Rt –10.95 –7.23 6.85 –0.479 –0.819 1
we will have a time series of filtered probability of Panel C: Likelihood, AIC and BIC
being in a given state. Following the literature, in Log-likelihood AIC BIC
order to find the determinants of this variable a logis- –3007.7 6063.4 6120.8
Note: *** and ** stand for significance at 1% and 5%, respectively.
tic regression will be performed. As explanatory vari-
able beyond the usual lagged state variable, we will use
the spread between the three-month Libor rate and Table 3. The estimation of the VAR model for CDX.NA.IG.HVOL
the three-month overnight index swap (OIS). We will with the whole sample (8 Dec 2004–8 Feb 2012).
also consider the spread between the 10-year interest Panel A: Regression coefficients

rate swap (Swap) and the OIS rate. The Libor and OIS Const. ΔCDSt1 ΔVOLt1 Rt1
ΔCDSt 0.4000 –0.0122 –1.5129*** –3.1185***
rates are provided by Datastream, while the swap rate ΔVOLt 0.0334 –0.0340*** –0.2350*** –0.1834
is provided by Bloomberg. Rt 0.0191 0.0278*** 0.1256* 0.2139**
Panel B: Covariance and correlation matrices
Covariance Correlation
ΔCDSt ΔVOLt Rt ΔCDSt ΔVOLt Rt
III. Models and analysis ΔCDSt 361.24 30.88 –29.09 1 0.488 –0.594
ΔVOLt 30.88 11.09 –6.91 0.488 1 –0.805
The VAR model Rt –29.09 –6.91 6.63 –0.594 –0.805 1
Panel C: Likelihood, AIC and BIC
We first carry out the joint analysis of the CDS, VIX Log-likelihood AIC BIC
and stock market indexes using the vector autore- –3145.1 6338.1 6395.6
gressive model with order 1 (VAR(1)) denoted as Note: ***, ** and * stand for significance at 1%, 5% and 10%, respectively.
 6 J. DA FONSECA AND P. WANG

the volatility with correlation of 0.451, but negatively (a)

10
related to stock returns with correlation of – 0.479;
and the volatility is negatively correlated to stock 8

returns with a value of – 0.819. These results support 6

the contemporaneous relationships between the vari- 4
ables described by Merton’s model. Furthermore, the
2
strength of these correlations indicates that the three
markets are strongly integrated, providing the basis 0
0 1 2 3 4 5
of various cross-hedging strategies among the three –2
markets with the market indexes as hedging instru- (b)
ments. In particular, as the equity index is negatively 4

correlated to the CDS and VIX indexes, the hedging 3

strategies for the equity risk created by the construc- 2

tion of a long position on either the CDS index or 1
Downloaded by [Central Michigan University] at 00:57 12 December 2015

the VIX index have some advantages as compared 0

1 2 3 4 5 6
with the traditional hedging strategies that generally –1
imply a short position on the hedging instrument. –2
In addition, the variable ΔCDSt–1 is significant in
–3
all the three regression equations, while ΔVOLt–1
(c)
and Rt1 are significant only in the regression equa- 2
tion for the CDS. It is therefore tempting to con- 1.5
clude that the CDS market drives the equity and 1
0.5
volatility markets as a Granger-causality test would
0
lead to this conclusion. For instance, an increase in 1 2 3 4 5 6
–0.5
ΔCDSt–1 will lead to a decrease in ΔVOLt and an –1
increase in Rt , given that both ΔVOLt–1 and Rt1 –1.5
remain constant. This indicates the intertemporal –2
–2.5
consistency of the lagged and contemporaneous rela-
tionships between the variables, i.e. the volatility and Figure 2. Impulse response functions for CDX.NA.IG based on
stock indexes will evolve over time in such a way the VAR model. (a) CDS shock, (b) VIX shock and (c) stock
return shock.
that the contemporaneous relationship between the
Note: The dashed, dashed-dot and dotted lines are the impulse
variables in time t is consistent with Merton’s model. responses of Δ CDS, Δ VOL and R, respectively.
To further examine the dynamic properties of the
three market indexes jointly, we computed the
impulse response function that traces the respon- that the instantaneous impact due to a VIX shock is
siveness of variables to one unit shock to each of positive for change in VIX index and negative for
the three factors underlying the transmission pro- stock returns, but almost none for change in the
cess. Figure 2 displays the impulse response func- CDS index. The subsequent impact over time dis-
tions. Note that we name a shock to the first factor appears quickly for all the variables, although it
as a CDS shock, to the second factor as a VIX shock appears a positive impact at lag 1 for CDS change.
and to the third factor as a stock return shock. Hence, a VIX shock will have a simultaneous impact
Figure 2(a) shows that the instantaneous impact on the stock and volatility markets only. Finally,
due to a CDS shock is positive for change in CDS Fig. 2(c) shows that instantaneous impact due to a
and VIX indexes, and negative for the stock return. stock return shock is positive for stock returns, but
The subsequent impact over time dies down quickly almost none for the CDS and VIX markets. The
for all the variables. Obviously a CDS shock will subsequent impact over time disappears quickly for
have a simultaneous impact on all the three markets, all the variables, while there is a negative impact at
especially the CDS market which usually is the least lag 1 for CDS change. These findings show the
liquid among these three markets. Figure 2(b) shows diversity of the information transmission process
 APPLIED ECONOMICS 7

among the three markets. It also indicates that in (a)

25
terms of instantaneous impact, a CDS shock plays a
more important role in the transmission process. 20

Any news affecting the CDS market also affects the 15

other two markets instantaneously, but not vice 10
versa. This suggests that credit/default risk has a
5
more profound effect on the three markets. This
feature should be considered in designing a hedging 0
0 1 2 3 4 5
strategy with market indexes, such as the use of VIX –5
and CDS indexes as hedging instruments studied by (b)
Caporin (2013). 3.5
3
For the CDX.NA.IG.HVOL, the results are simi- 2.5
lar to those for the CDX.NA.IG. Particularly, the 2
1.5
correlation matrix is almost identical to the one for 1
Downloaded by [Central Michigan University] at 00:57 12 December 2015

the CDX.NA.IG with the exception of the correla- 0.5

0
tion between the CDS and the equity returns which –0.5 0 1 2 3 4 5
appears to be stronger (in absolute value). The –1
main difference in the variance matrix is that the –1.5
–2
CDX.NA.IG.HVOL has a much larger variance
(c)
than the CDX.NA.IG because the former includes 2
riskier CDS products. As for the regression coeffi- 1
cients, all the significant coefficients have the same 0
sign for the two CDS indexes. However, the num- 0 1 2 3 4 5
–1
ber of significant coefficients is 7 for this CDS
–2
index, 2 more than that for the CDX.NA.IG. We
–3
also computed the impulse response function for
this CDS index. The graphs of the impulse response –4

function for the CDX.NA.IG.HVOL in Fig. 3 are –5

quite similar to the corresponding graphs in Fig. 2,
except that the magnitude of the response of ΔCDS
to CDS shock is larger for the CDX.NA.IG.HVOL.4
This means that the joint dynamic system for the
CDX.NA.IG.HVOL change, VIX change and the
stock return is similar to that for the case of CDX.
NA.IG change, VIX change and stock return.
Therefore, in terms of risk management using a
CDS index as a hedging instrument, the two CDS
indexes could be interchangeable with different
hedging ratios.
The Markov-switching VAR model
Financial markets tend to change their behaviour
suddenly over time and the changed behaviour
often persists for some time. For example, the
mean, volatility and correlation patterns for the
CDS, VIX and stock markets changed abruptly
4
We omit the graphs to save space, which are available from the authors upon request.
Figure 3. Impulse response functions for CDX.NA.IG.HVOL
based on the VAR model. (a) CDS shock, (b) VIX shock and
(c) stock return shock.
The dashed, dashed-dot and dotted lines are the impulse
responses of Δ CDS, Δ VOL and R, respectively.
and dramatically at the start of the recent global
financial crisis and the new dynamics persisted
through many months. While under the VAR
model the joint dynamic system of the three mar-
kets specified by Equation (1) is assumed to
remain constant over time, a Markov-switching
VAR model allows the joint dynamic system to
change abruptly. It can parsimoniously capture
stylized behaviour of the market indexes such as
persistent periods of turbulence followed by per-
sistent periods of low volatility and time-varying
correlation, and can handle heterogeneity in
the data. As we want to compare the
 8 J. DA FONSECA AND P. WANG

Table 4. Markov-switching estimation for CDX.NA.IG with the whole sample (13 Oct 2004–8 Feb 2012).
Panel A: Regression coefficients
Regime no. Const. ΔCDSt1 VOLt1 Rt1
ΔCDSt 1 –0.1575 0.2632*** –0.1178 –0.1690
2 0.4877 –0.2439*** –0.8491** –2.0120***
VOLt 1 –0.0686 0.1393*** –0.2192*** 0.0698
2 0.2267 –0.0855*** –0.1328 –0.0066
Rt 1 0.3012*** –0.1243*** 0.1200 –0.0138
2 –0.3485 0.0791*** 0.0305 0.0628
Panel B: Covariance and correlation matrices
Covariance Correlation
Regime 1 Regime 2 Regime 1 Regime 2
ΔCDSt t Rt ΔCDSt VOLt Rt ΔCDSt VOLt Rt ΔCDSt VOLt Rt
ΔCDSt 3.63 0.43 –0.61 148.45 25.36 –20.29 1 0.211 –0.292 1 0.448 –0.480
VOLt 0.43 1.14 –0.87 25.36 21.62 –13.26 0.211 1 –0.741 0.448 1 –0.822
Rt –0.61 –0.87 1.21 –20.29 –13.26 12.03 –0.292 –0.741 1 –0.480 –0.822 1
Panel C: Transition probabilities, log-likelihood, AIC and BIC
p11 p22 Log-likelihood AIC BIC
Downloaded by [Central Michigan University] at 00:57 12 December 2015

0.8715 0.8569 – 2639.5 5355.0 5546.7

Note: *** and ** stand for significance at 1% and 5%, respectively.

Markov-switching VAR model to the simple
VAR model, we consider the following Markov-
switching VAR model:
Δxt ¼ as0t þ as1t Δxt1 þ
t st 2 f1; 2g;
where
t jst ,Nð0; Ωst Þ and st follow a two-state first-
order Markov chain with transition probabilities:
P½st ¼ jjst1 ¼ i ¼ pij i; j 2 f1; 2g:
Note that as0t ; as1t
and Ωst are state-dependent vec-
tors/matrices of parameters, and the model para-
meter vector θ contains all the unknown elements
of pij ; as0t ; as1t and Ωst .
Under the Markov-switching VAR model, there
are two regimes for the dynamic process of the three
markets, which is characterized by the correspond-
ing conditional mean structure defined by ðas0t ; as1t Þ
and conditional covariance matrix Ωst . The two
regimes switch according to a two-state Markov
chain. Furthermore, the state is assumed to be unob-
servable and has to be inferred from data.
Given a sample of observations ZT ¼
fΔxT ; ΔxT1 ; . . . ; Δx1 g, we obtain the maximum-
likelihood estimate of θ via the EM algorithm
using the method described in Hamilton (1994,
Chapter 22). We then use the resulting maximum-
likelihood estimate ^θ to form an inference about the
latent state for week t with the smoothing probabil-
ity defined by
Pðst ¼ 1jZT ; ^θÞ:
We perform the estimation of this model for both
indexes using the whole sample and report the
results in Tables 4 and 5 for the CDX.NA.IG and
CDX.NA.IG.HVOL, respectively.
(2)
For the CDX.NA.IG, it confirms that there is
evidence for the regime-switching in the three mar-
kets because both the AIC and BIC values reported
in Panel C of Tables 2 and 4 lead to the selection of
(3)
the Markov-switching VAR model over the VAR
model. Moreover, Panel B of Table 4 shows that
for each of the three markets, the conditional var-
iance for regime two is higher than the correspond-
ing variance for regime one. Hence, the two regimes
are referred to as low- and high-volatility regimes
with regime 1 representing the quiescent periods of
the three markets and regime 2 for the turbulent
periods. As in the case of the VAR model, the con-
ditional correlation matrix is consistent with theory
for both regimes as the correlation signs are the
same as those for the VAR model. Furthermore,
while the correlation between the CDS and VIX
indexes under regime 2 is much higher than that
under regime 1, either of the CDS and VIX indexes
is more strongly, negatively correlated to the equity
index. This suggests that credit and volatility risk are
more interrelated during turbulent periods. It also
indicates that the use of the CDS and VIX indexes as
a diversification tool becomes more significant dur-
ing turbulent periods.
Unlike the VAR model, the covariance and corre-
(4) lation across indexes under the Markov-switching
 APPLIED ECONOMICS 9

Table 5. Markov-switching estimation for CDX.NA.IG.HVOL with the whole sample (8 Dec 2004–8 Feb 2012).
Panel A: Regression coefficients
Regime Const. ΔCDSt1 VOLt1 Rt1
ΔCDSt Reg. 1 –0.0348 –0.1234** –0.9079** –1.0911**
Reg. 2 –0.4642 0.0124 –1.7809* –3.8415***
VOLt Reg. 1 –0.0553 –0.0091 –0.4346*** –0.2455
Reg. 2 0.2236 –0.0449** –0.1787 –0.1769
Rt Reg. 1 0.3177*** 0.0045 0.1431 0.0666
Reg. 2 –0.4022 0.0386** 0.1018 0.2370
Panel B: Covariance and correlation matrices
Covariance Correlation
Regime 1 Regime 2 Regime 1 Regime 2
ΔCDSt VOLt Rt ΔCDSt VOLt Rt ΔCDSt VOLt Rt ΔCDSt VOLt Rt
ΔCDSt 30.54 4.39 –4.41 812.80 69.29 –64.62 1 0.545 –0.577 1 0.501 –0.632
VOLt 4.39 2.13 –1.66 69.29 23.49 –14.04 0.545 1 –0.823 0.501 1 –0.808
Rt −4.41 – 1.66 1.91 –64.62 –14.04 12.85 –0.577 –0.823 1 –0.632 –0.808 1
Panel C: Transition probabilities, log-likelihood, AIC and BIC
p11 p22 Log-likelihood AIC BIC
Downloaded by [Central Michigan University] at 00:57 12 December 2015

0.9147 0.881 – 2808.5 5693.1 5883.2

Note: ***,** and * stand for significance at 1%, 5% and 10%, respectively.

model are time-varying. Thus, the optimal hedge
ratio based on the Markov-switching model varies
over time. For example, when the three markets are
in regime 1, the optimal hedge ratio for hedging
CDS risk is 0.37 ð¼ 0:43=1:14Þ for the VIX index
and – 0.5 ð¼ 0:61=1:21Þ for the equity index. On
the other hand, when the three markets are in
regime 2, the optimal hedge ratio for hedging the
CDS risk is 1.19 ð¼ 25:36=21:62Þ for the VIX index
and – 1.68 ð¼ 20:29=12:03Þ for the equity index.
In this case, the change in the optimal hedge ratio
between the two regimes is 3.2 times for the VIX
index and 3.3 times for the equity index. Note that
the corresponding two hedge ratios for the VAR
model are 1.17 ð¼ 13:31=11:31Þ and – 1.159
( ¼ 10:95=6:85), respectively. As the joint
dynamics of the three market indexes is better char-
acterized by the Markov-switching model rather
than the VAR model in terms of both AIC and
BIC, the construction of hedging strategies based
on the VAR model may lead to either over or
under hedging. Therefore, from a risk management
point of view it is important to construct hedging
strategies based on the Markov-switching model.
As p11 ¼ 0:872 (p22 ¼ 0:857), when the markets
are in the low (high) volatility regime for a week,
there is 87:2% (85:7%) chance that the markets
remain in the same regime next week, and 12:8%
(14:3%) chance that the markets switch to the high
(low) volatility regime next week. This means that
either of the two regimes is quite persistent. In the
long run, the markets are in the low (high) volatility
regime for 52:7% (47:3%) of the time as the station-
ary probabilities are 0.527 and 0.473 for the low and
high regimes, respectively. Moreover, the expected
number of consecutive weeks in the same regime is
7.8 weeks for the low-volatility regime and 7.0 weeks
for the high-volatility regime.
Panel A of Table 4 shows that for regression
coefficients, the variable ΔCDSt–1 is significant in
all the three regression equations for both regimes,
whereas ΔVOLt–1 and Rt1 are significant only for
the CDS equation for regime 2, and ΔVOLt–1 is only
significant in the VIX equation for regime 1.
Obviously the conditional mean structure is differ-
ent for the two regimes. Moreover, for either of the
two regimes, there is the intertemporal consistency
of the lagged and contemporaneous relationships
between the variables, so that the contemporaneous
relationship between the variables at any time is
consistent with Merton’s model. For example,
under regime 1, an increase in ΔCDSt–1 will lead
to an increase in ΔCDSt and ΔVOLt but a decrease
in Rt , given that both ΔVOLt–1 and Rt1 remain
constant; and under regime 2, an increase in
ΔCDSt–1 will lead to a decrease in ΔCDSt and
ΔVOLt but an increase in Rt , given that both
ΔVOLt–1 and Rt1 remain constant. This implies
that at time t the CDS and VIX indexes are posi-
tively correlated but they are negatively related to
the stock index. To further examine the dynamic
properties of the three markets under either of the
 10 J. DA FONSECA AND P. WANG

(a)

2.5 14
12
2
10
1.5 8
6
1
4
0.5 2
0
0 1 2 3 4 5 6
0 1 2 3 4 5 –2
–0.5 –4

(b)

4 5
3 4

2 3
Downloaded by [Central Michigan University] at 00:57 12 December 2015

2
1
1
0
1 2 3 4 5 6 0
–1 0 1 2 3 4 5
–1
–2 –2
–3 –3

(c)
2 3
1.5 2
1 1
0.5
0
0 0 1 2 3 4 5
0 1 2 3 4 5 –1
–0.5
–2
–1
–1.5 –3
–2 –4
–2.5 –5

Figure 4. Impulse response functions for the CDX.NA.IG based on the MS model. (a) CDS shock, (b) VIX shock and (c) return shock.
The dashed, dashed-dot and dotted lines are the impulse responses of Δ CDS, Δ VOL and R, respectively. The left-hand-side figures
report the first state, and the right-hand-side figures report the second state.

two regimes, we computed the impulse response
functions in the same way as in the VAR model by
treating the matrix of the conditional regression
coefficients ðas1t Þ and the conditional covariance
(Ωst ) for a regime as the corresponding matrices
(a1 and Ω) in the VAR model. The impulse response
functions are displayed in Fig. 4 where the left-
hand-side three panels are for regime 1, and the
right-hand-side three panels are for regime 2.
In Fig. 4, each response curve in the right-hand-
side panel has a similar but enlarged shape as com-
pared with the curve in the corresponding left-hand-
side panel. This suggests that the structure of the
transmission process in the three markets remains
stable when the markets switch between the two
regimes over time. It also indicates that the impact
of shock to the markets is relatively larger during
high-volatile periods than during low-volatile peri-
ods. In addition, the interpretation of the dynamic
system of the three markets under either of the two
regimes is almost the same as for the VAR model,
because each response curve in Fig. 4 is also similar
to that for the VAR model in Fig. 2. These findings
imply that although hedging ratio may vary over
time, it is relatively stable for the construction of a
hedging strategy against credit or volatility or equity
risk.
We also look into the effects of GDP growth and
inflation shocks on the three financial markets by
examining the correlation between the residuals
 APPLIED ECONOMICS 11

generated from the first-order autoregression of Panel A: CDS (CDS.NA.IG), VIX, S&P500 prices
1800 80
changes in the US real GDP growth and inflation 1600 70
rate and the residuals generated from the Markov- 1400 60

CDS, S&P500
1200
switching VAR model.5 The residuals for GDP 1000
50

VIX
40
growth have the correlation coefficients of –0.19, – 800
600 30
0.7 and 0.63 with the residuals for the CDS, VIX and 400 20
200 10
equity markets, respectively, based on the CDX.NA. 0 0
IG data, and – 0.27, – 0.60 and 0.41 for the three

10/2004
04/2005
10/2005
04/2006
10/2006
04/2007
10/2007
04/2008
10/2008
04/2009
10/2009
04/2010
10/2010
04/2011
10/2011
markets, respectively, based on the CDX.NA.IG.
HVOL data. This indicates that shocks to GDP CDS SP500 VIX

growth have a negative impact on the CDS and Panel B: Estimated standard deviations
VIX markets, and a positive impact on the equity 12.00
market. The residuals for inflation have the correla- 10.00
tion coefficients of –0.05, 0.01 and 0.30 with the 8.00
Downloaded by [Central Michigan University] at 00:57 12 December 2015

residuals for the CDS, VIX and equity markets, 6.00

respectively, based on the CDX.NA.IG data, and – 4.00
0.03, 0.15 and 0.18 for the three markets, respec- 2.00
tively, based on the CDX.NA.IG.HVOL data. This 0.00
shows that shocks to inflation have a negative impact

on the CDS market, and a positive impact on both
the VIX and equity markets. Furthermore, the
impact of inflation shocks on the three markets is
less as compared with GDP shocks.
Finally, we calculate the estimated smoothing
probability defined by Equation (4) and use it to
identify week t with the low-volatility regime if the
smoothing probability of being in the low-volatility
regime exceeds 0.5, and the high-volatility regime
otherwise. The classification is presented in the two
panels of Fig. 5 where the unshaded and shaded
areas represent the periods of low- and high-volati-
lity regimes, respectively. Clearly, before the global
financial crisis, the markets are in the low-volatility
regime for most of the time, while after the global
financial crisis the markets are more often in the
high-volatility regime.
The estimation results for the CDX.NA.IG.HVOL
are similar to those for the CDX.NA.IG. In particu-
lar, the Markov-switching VAR model is superior to
the VAR model according to both AIC and BIC
values in Panel C of Tables 3 and 5. Panel B of
Table 5 shows that the two regimes can be charac-
terized as low- and high-volatile market conditions.
In addition, the conditional correlation matrices for
the two regimes are comparable. Particularly, the
10/2004
04/2005
10/2005
04/2006
10/2006
04/2007
10/2007
04/2008
10/2008
04/2009
10/2009
04/2010
10/2010
04/2011
10/2011
CDS VIX S&P500
Figure 5. CDX.NA.IG classification. Weekly observations from 13
October 2004 to 8 February 2012.
sign of each element in the conditional correlation
matrices for the case of the CDX.NA.IG.HVOL is
the same as for the case of the CDX.NA.IG. This
indicates that the construction of hedging strategies
should be also similar for the two cases. However,
since the equity index is less correlated to the CDX.
NA.IG.HVOL than the CDX.NA.IG under either of
the two regimes, the CDX.NA.IG.HVOL is likely
more preferred in terms of portfolio diversification.
In addition, as p11 ¼ 0:915 (p22 ¼ 0:881), when the
markets are in the low (high) volatility regime for a
week, there is 91:5% (88:1%) chance that the markets
remain in the same regime next week, and 8:5%
(11:9%) chance that the markets switch to the high
(low) volatility regime next week. Like the CDX.NA.
IG index, either of the two regimes is quite persistent.
In the long run, the markets are in the low (high)
volatility regime for 58:3% (41:7%) of the time as the
stationary probabilities are 0.583 and 0.417 for the low
and high regimes, respectively. Moreover, the

5
The quarterly US real GDP and monthly US CPI data are downloaded from the website of the Federal Reserve Bank of St. Louis. We first obtain the residuals
from the first-order autoregression of the quarterly changes in the US real GDP growth and the monthly changes in the US CPI separately, and we then
calculate the sample correlation coefficients between these residuals and the residuals of the Markov-switching model that are next to the corresponding
residuals from the autoregression in terms of time.
 12 J. DA FONSECA AND P. WANG

expected number of consecutive weeks in the same financial crisis the markets are more often in the
regime is 11.8 weeks for the low-volatility regime and high-volatility regime.
8.4 weeks for the high-volatility regime.
Panel A of Table 5 shows that the conditional
Out-of-sample forecast
mean structure is different for the two regimes. For
instance, the variable ΔCDSt1 in the CDS regres- For out-of-sample forecast performance, we consider
sion equation is significant only for regime 1. As in both point and interval forecasts for the response
the case of the CDX.NA.IG, we also computed the variables. For point forecasts, given information
impulse response functions to examine the dynamic available up to period t, 1-period-ahead forecasts
system of the three markets for the two regimes. The for the variables of Δxtþ1 are generated from the
graphs of the impulse response functions are similar VAR model as follows:
to those for the CDX.NA.IG, suggesting that the
Δ^xtþ1jt ¼ ^a0 þ ^a1 Δxt ; (5)
dynamic system is comparable for both cases; thus
we omit the graphs here. where ^a0 and ^a1 are the parameter estimates
obtained based on observations through period t.
Downloaded by [Central Michigan University] at 00:57 12 December 2015

As in the case of CDX.NA.IG index, we use the

smoothing probabilities to identify each week with For the Markov-switching VAR model, given
either of the two regimes in terms of the same information available up to period t, we first forecast
classification criterion. The results are shown in how likely the markets are to be in a particular state
Fig. 6 where the unshaded and shaded areas repre- in period t þ 1 by calculating the following condi-
sent the periods of low- and high-volatility regimes, tional probabilities:
respectively. Like the CDX.NA.IG, before the global
^tþ1jt ¼ P^
P ^ ptjt ; (6)
financial crisis the markets are in the low-volatility
regime for most of the time, while after the global
where P ^ tþ1jt ¼ ðPðstþ1 ¼ 1jZt ; ^θÞ; ðstþ1 ¼ 2jZt ; ^θÞÞT ,
and ^θ, P
^ and p ^tjt are the estimated model parameters,
Panel A: CDS (CDX.NA.IG.HVOL),VIX and S&P500 2  2 matrix of the transition probabilities and
prices
smoothing probabilities, respectively. We then deter-
2000 80
70 mine the forecasts for Δxtþ1 using the following
1500 60
equations:
CDS, SP500

50
VIX

1000 40
ðiÞ ðiÞ ðiÞ
500
30 Δ^xtþ1jt ¼ ^a0 þ ^a1 Δxt i ¼ 1; 2; (7)
20
10
0 ð1Þ ð2Þ
^tþ1jt :
0
Δ^xtþ1jt ¼ ðΔ^xtþ1jt Δ^xtþ1jt ÞP (8)
12/2004
06/2005
12/2005
06/2006
12/2006
06/2007
12/2007
06/2008
12/2008
06/2009
12/2009
06/2010
12/2010
06/2011
12/2011

Note that all the parameter estimates are obtained

CDS SP500 VIX based on observations through period t.
As for interval forecasts, we construct out-of-sample
Panel B: Estimated standard deviations
interval forecasts for each of the three
30.00
response variables Δxj;tþ1 ðj ¼ 1; 2; 3Þ in the form:
25.00
ðLj;tþ1jt ðpÞ; Uj;tþ1jt ðpÞÞ, where Lj;tþ1jt ðpÞ and
20.00
15.00
Uj;tþ1jt ðpÞ are the lower and upper limits of the inter-
10.00 val, and they are the p2 th and ð1  p2Þth quantile of
5.00 conditional distribution of Δxj;tþ1 , respectively. Note
0.00 that the conditional distribution of Δxj;tþ1 is a normal
12/2004
06/2005
12/2005
06/2006
12/2006
06/2007
12/2007
06/2008
12/2008
06/2009
12/2009
06/2010
12/2010
06/2011
12/2011

distribution for the VAR model with the mean pre-

dicted by Equation (5) and the estimated variance
CDS VIX S&P500 based on observations up to period t, and a mixture
Figure 6. CDX.NA.IG.HVOL classification. Weekly observations of two normal distributions for the Markov-switching
from 8 December 2004 to 8 February 2012. VAR model with the component means predicted by

Equation (7), the estimated component variances
based on observations up to period t and the mixing
probabilities calculated by Equation (6).
To evaluate point of out-of-sample forecast per-
formance, we calculate root-mean-squared error
(RMSE) as follows:
1 X 3 TXout 1
RMSE ¼ ðΔ^xj;tþ1jT  Δxj;tþ1 Þ2 ;
3Tout j¼1 t¼Tþ1
where T and Tout are in-sample and out-of-sample
sizes, respectively. To evaluate interval out-of-sample
forecast performance, we calculate the average cov-
Downloaded by [Central Michigan University] at 00:57 12 December 2015
erage rate that an observation lies within the corre-
sponding interval, and conduct the three likelihood
ratio tests for the performance of out-of-sample
interval forecast as proposed by Christoffersen
(1998).6
For out-of-sample period from 15 February 2012
to 14 November 2012 (Tout ¼ 40 weeks), the value of
RMSE for point forecast is 4.1 for both the VAR and
Markov-switching VAR models for the data of CDX.
NA.IG, and is 6.7 for the VAR model and 6.5 for the
Markov-switching model for the data of CDX.NA.
IG.HVOL, respectively. This means that the point
forecast based on the Markov-switching model is not
inferior to the one based on the VAR model.
Table 6 reports the average coverage rates for
five different interval forecasts by the two models
with the true coverage rate p ¼ 50%, 60%, 70%,
80% and 90%, respectively. It shows that for both
data sets, the average rates by the Markov-switch-
ing model are closer to the corresponding true
rates. Furthermore, the test statistics for interval
forecasts are plotted in Fig. 7 where LRcc , LRuc
Table 6. Average coverage rates of p% out-of-sample interval
forecasts.
Panel A: CDX.NA.IG
p% 50% 60%
VAR model
Markov-switching model
0.63
0.50
0.75
0.58
Panel B: CDX.NA.IG.HVOL
p% 50% 60%
VAR model 0.68 0.82
Markov-switching model 0.44 0.54
6
Christoffersen (1998) introduces the three hypotheses: conditional coverage, independence and unconditional coverage, for assessing the validity of an
interval forecast obtained by using any type of models. If an interval forecast is efficient with respect to given information, then all the three hypotheses
should hold.
APPLIED ECONOMICS 13
and LRind are the likelihood ratio test statistics for
the conditional coverage, unconditional coverage
and independence hypotheses, respectively, the
solid (dotted) curves represent the values of the
test statistics based on the VAR (Markov switch-
ing) model, and the horizontal solid lines are the
critical values for the tests. There is no evidence to
reject any of the three hypotheses for the Markov-
switching model except the two cases for the 70%
interval forecast for the variable ΔCDSt for the
(9)
CDX.NA.IG data. On the other hand, there are
many cases where the three hypotheses are rejected
for the VAR model. Clearly, the interval forecast
based on the Markov-switching model is better
than that based on the VAR model.
IV. The determinants of regime-switching
In this section, we investigate possible factors that
affect the switching between the two regimes of the
three markets. More specifically, we examine whether
and how the change and volatility in each of the CDS,
VIX and equity markets have impacted on the regime-
switching mechanism. We also look into whether or
not the volatility in the money market has any influ-
ence on forcing the indexes of the CDS, VIX and equity
markets from one regime to another.
As the state variable st of the Markov-switching
VAR model is unobservable, we make inference
about st using the smoothing probability defined in
Equation (4). Hence, to examine the determinants of
the regime-switching, we regress the estimated state
variable on each of the possible explanatory variables
using the logistic regression specification defined by
Pðst ¼ 1Þ ¼ logitðα0 þ α1 xt Þ
expðα0 þ α1 xt Þ
¼ ; (10)
1 þ expðα0 þ α1 xt Þ
where xt is a given explanatory variable. Note that
with a positive value of α1 an increase in xt will
70% 80% 90% result in a probability of being in regime 1 (low
0.88
0.66
0.94
0.80
0.98
0.90
volatility), while with a negative value of α1 an
increase in xt will result in a larger probability of
70% 80% 90% being in regime 2 (high volatility).
0.88 0.96 0.98 To take into account possible different effects of a
0.66 0.74 0.86 determinant of regime-switching at the three
 14 J. DA FONSECA AND P. WANG

(a)
Dcds Divx Rsp

0 5 10 15 20

0 5 10 15 20

0 5 10 15 20
LRcc

LRcc

LRcc
50% 60% 70% 80% 90% 50% 60% 70% 80% 90% 50% 60% 70% 80% 90%
p% interval forecast p% interval forecast p% interval forecast

Dcds Divx Rsp

0 5 10 15 20
0 5 10 15 20

0 5 10 15 20
LRuc
LRuc

LRuc
50% 60% 70% 80% 90% 50% 60% 70% 80% 90% 50% 60% 70% 80% 90%
p% interval forecast p% interval forecast p% interval forecast
Downloaded by [Central Michigan University] at 00:57 12 December 2015

Dcds Divx Rsp

0 1 2 3 4

0 1 2 3 4

0 1 2 3 4
LRind
LRind

LRind
50% 60% 70% 80% 90% 50% 60% 70% 80% 90% 50% 60% 70% 80% 90%
p% interval forecast p% interval forecast p% interval forecast

(b)
Dcds Divx Rsp
5 10 15

5 10 15

5 10 15
LRcc
LRcc

LRcc
0

50% 60% 70% 80% 90% 50% 60% 70% 80% 90% 50% 60% 70% 80% 90%
p% interval forecast p% interval forecast p% interval forecast
Dcds Divx Rsp
5 10 15

5 10 15

5 10 15
LRuc
LRuc

LRuc
0

50% 60% 70% 80% 90% 50% 60% 70% 80% 90% 50% 60% 70% 80% 90%
p% interval forecast p% interval forecast p% interval forecast

Dcds Divx Rsp

0 1 2 3 4 5 6

0 1 2 3 4 5 6

0 1 2 3 4 5 6
LRind
LRind

LRind

50% 60% 70% 80% 90% 50% 60% 70% 80% 90% 50% 60% 70% 80% 90%
p% interval forecast p% interval forecast p% interval forecast

Figure 7. Test statistics for out-of-sample interval forecast. (a) CDX.NA.IG and (b) CDX.NA.IG.HVOL.

different phases of the recent global finance crisis: specification. This allows us to ascertain whether or
before, during and after the crisis, we split our sam- how the global financial crisis affected the cross-
ple into three sub-samples, namely pre-crisis, crisis market linkages. We report the results for the
and post-crisis as described in the data section, and CDX.NA.IG and CDX.NA.IG.HVOL in Tables 7
fit each sub-sample to the above logistic and 8, respectively.
 APPLIED ECONOMICS 15

Table 7. Logistic regression for the CDX.NA.IG. sign. Thus, an increase in either of the two variables
Variable Pre-crisis Crisis Post-crisis
ΔðLibor  OISÞ2t and ΔðSwap  OISÞ2t may drive all
ΔCDSt1 –0.5427*** 0.0074 –0.0810**
ΔCDS2t1 –0.0253** –0.0006 –0.0142** the three market indexes from the low-volatility
ΔVOLt1 –0.1869 0.0121 –0.0256 regime to the high-volatility regime. While many
ΔVOL2t1 –0.0404 –0.0139 –0.1126***
Rt1 0.1952 –0.0179 0.1038 empirical studies have revealed the relevance of the
R2t1 –0.1031 –0.0340 –0.1570*** Libor–OIS spread as an explanatory variable or a key
ΔðLibor  OISÞ2t1 0.1052 –0.3277 –11.0353**
–4.1468*** –1.8529** –5.3161*
indicator of the credit (liquidity) crisis during the
ΔðLibor  OISÞ2t
ΔðSwap  OISÞ2t1 –0.0961 –0.1156 –0.0733 global financial crisis (e.g. Michaud and Upper 2008;
ΔðSwap  OISÞ2t –0.0133 –0.3644** –0.2444** Williams and Taylor 2009; Ji 2012; Ji and In 2010;
Note: ***, ** and * stand for significance at 1%, 5% and 10%, respectively. Baba and Packer 2009; Gefang, Koop, and Potter
2011),7 our findings shed some light on not only
the role of the volatility of this spread in the CDS
Table 8. Logistic regression for the CDX.NA.IG.HVOL.
Variable Pre-crisis Crisis Post-crisis
market but also its impact on the equity and volati-
ΔCDSt1 –0.0894* –0.0082 –0.0429** lity markets during the global financial crisis.
Downloaded by [Central Michigan University] at 00:57 12 December 2015

ΔCDS2t1 –0.0133*** 0.0000 –0.0053*** Moreover, since ΔðLibor  OISÞ2t and ΔðSwap 
ΔVOLt1 0.2083 –0.0104 –0.0770
ΔVOL2t1 –0.0777* –0.0164 –0.0338*** OISÞ2t are both important in the regime-switching,
Rt1 –0.1805 0.0660 0.2071***
R2t1 –0.0336 –0.0655** –0.0753*** it suggests that both the spreads share some com-
ΔðLibor  OISÞ2t1 –8.1311*** –0.4124 –7.0913* mon information. This also provides empirical evi-
ΔðLibor  OISÞ2t –8.6351*** –0.1959 –7.1000* dence consistent with the theoretical properties
ΔðSwap  OISÞ2t1 0.1235 –0.0216 –0.1208
–0.2040 –0.2211* –0.1384*
shown in Filipović and Trolle (2013) that the
ΔðSwap  OISÞ2t
Note: ***,** and * stand for significance at 1%, 5% and 10%, respectively.
Swap–OIS spread reflects risk-neutral expectation
about the future Libor–OIS spread and contains
‘forward’ information on short-term credit risk.
For the CDX.NA.IG case, during the pre-crisis per- The last column of Table 7 shows that during the
iod the change in the CDS index and volatility in the post-crisis period the information from each of the
CDS market have a significant impact on the regime- markets becomes important in the regime-switching
switching of the three markets as both ΔCDSt–1 and mechanism. Particularly, an increase in volatility in
ΔCDS2t1 are significant with a negative coefficient. This any of the three market indexes will increase
indicates that the concern of credit deterioration by the chance that the three markets will be in the
investors may increase CDS spread and its volatility, high-volatility regime because ΔCDS2t1 , ΔVOL2t1
forcing all the three market indexes to be in the high- and R2t1 are all significant with a negative sign.
volatility regime. It also implies that among the three Conversely, the effect of the volatility in the money
markets the changes in the CDS market index may lead market on the regime-switching becomes larger dur-
to the switching between the two regimes. Additionally, ing the post-crisis period than the pre-crisis period as
the volatility in the money market measured by the coefficients for the square of the change in either
the Libor–OIS spread or the Swap–OIS spread are
ΔðLibor  OISÞ2t plays an important role in the
more negative for the post-crisis period than for the
regime-switching of the three markets during the pre-
pre-crisis period. These findings suggest that the
crisis period because ΔðLibor  OISÞ2t is significant
cross-market linkages become stronger after the crisis.
with a negative sign. With an increase in ΔðLibor  For the CDX.NA.IG.HVOL case, the results are
OISÞ2t it is more likely that the three market indexes will quite similar to those for the CDX.NA.IG case. The
be in the high-volatility regime. main difference between the two cases is that for the
During the crisis period, the volatility in CDX.NA.IG.HVOL there are more significant vari-
the money market is the only significant factor of ables during the pre- and post-crisis periods. For
the regime-switching as ΔðLibor  OISÞ2t and example, unlike the case of the CDX.NA.IG,
ΔðSWAP  OISÞ2t are significant with a negative ΔVOL2t1 is significant with a negative sign during
7
Note that the widening of this spread led to rewrite the theory of interest rate derivatives, the so-called multi-curve approach, see among the works of
Johannes and Sundaresan (2007), Fujii, Shimada, and Takahashi (2010) and Mercurio (2010).
 16 J. DA FONSECA AND P. WANG
the pre-crisis period. This means that an increase in
volatility in the VIX market will increase the chance of
being in the high-volatility regime. As the CDX.NA.
IG.HVOL includes riskier CDS products than the
CDX.NA.IG, our results show that the regime-switch-
ing is more sensitive to any change in the three market
indexes as well as in the volatility in the money market.
V. Conclusion
In this study, we have examined the joint behaviour of
the CDS, VIX and stock markets using both VAR and
Markov regime-switching VAR models with market
index data. Specifically, we have considered either of
Downloaded by [Central Michigan University] at 00:57 12 December 2015
the two CDS market indexes: CDX.NA.IG and CDX.
NA.IG.HVOL together with the VIX for the volatility
market index and the S&P500 for the stock market
index, and used weekly data of changes in the market
indexes for the period from October 2004 to February
2012 in the case of the CDX.NA.IG and from
December 2004 to February 2012 in the case of the
CDX.NA.IG.HVOL. Our study shows that the joint
behaviour of the three markets is better characterized
by the Markov regime-switching model rather than the
VAR model, in which the structural change in the joint
dynamics of the three markets follows a two-state
Markov chain with two regimes corresponding to
quiescent and volatile periods. Under either of the
two regimes, the structure of the mean, variance and
correlation of the changes in the market indexes is
consistent with theory; and each regime appears per-
sistent over time, which makes it possible for fund
managers to manage a cross-market portfolio effec-
tively with regime-dependent strategies.
Furthermore, our findings indicate that the struc-
ture of the information transmission process of
shocks to the markets is almost the same for the
two regimes. Shock to the CDS market has an
instantaneous effect on the other two markets, but
not vice versa. This provides evidence that the
changes in the CDS market play a more important
role among the three markets. We have also pro-
vided empirical evidence for the impact of GDP
growth and inflation shocks on the three financial
markets; and our findings show that GDP growth
shock affects the three markets more than inflation
shock with a positive effect on the stock market and
a negative effect on the CDS and VIX markets.
We have also conducted out-of-sample point and
interval forecasts for the response variables; and our
findings indicate that the out-of-sample forecasts
based on the Markov regime-switching VAR model
is better than the one based on the VAR model.
In addition, we have investigated the determi-
nants of the regime-switching mechanism during
the pre-crisis, crisis and post-crisis periods of the
recent global financial crisis. We have found that
the volatility in the money market measured by
square of either the Libor–OIS spread or the Swap–
OIS spread is the only factor that is significant
throughout all the three periods. Particularly, the
higher the volatility in the money market, the more
likely the three market indexes will be in the high-
volatility regime. In addition, our findings show that
the changes and the volatilities of the three market
indexes become more important for the regime-
switching during the post-crisis period than the
pre-crisis period. This provides empirical evidence
that the linkages between the three markets have
become stronger after the global financial crisis.
Finally, our study also shows that hedge ratios are
quite sensitive to the regime, which has practical impli-
cations for designing hedging strategies with market
indexes. The joint dynamics of the three markets based
on the Markov model can provide optimal hedge ratios
with various market indexes for different hedging stra-
tegies under different market conditions. Our findings
extend the results of Caporin (2013) in several ways,
including the use of any of the three market indexes as
a hedging instrument during quiescent and turbulent
periods. The development of an optimal cross-market
portfolio with either market or sector indexes based on
the Markov regime-switching model is an interesting
topic for future research.
Disclosure statement
No potential conflict of interest was reported by the authors.
ORCID
José Da Fonseca http://orcid.org/0000-0002-6882-4511
References
Alexander, C., and A. Kaeck. 2008. “Regime Dependent
Determinants of Credit Default Swap Spreads.” Journal

of Banking & Finance 32 (6): 1008–1021. doi:10.1016/j.
jbankfin.2007.08.002.
Baba, N., and F. Packer. 2009. “Interpreting Deviations From
Covered Interest Parity during the Financial Market
Turmoil of 200708.” Journal of Banking & Finance 33
(11): 1953–1962. doi:10.1016/j.jbankfin.2009.05.007.
Bai, J., and P. Collin-Dufresne. 2011. “The CDS-Basis.”
Working Paper SSRN-2024531. doi:10.2139/ssrn.2024531.
Benkert, C. 2004. “Explaining Credit Default Swap Premia.”
Journal of Futures Markets 24 (1): 71–92. doi:10.1002/
fut.10112.
Binder, M., and M. Gross. 2013. “Regime-Switching Global
Vector Autoregressive Models.” Working Paper ECB-
1569. http://ssrn.com/abstract=2302510.
Byström, H. 2008. “Credit Default Swaps and Equity Prices:
The iTraxx CDS Index Market.” In Credit Risk-Models,
Derivatives, and Management-Financial Mathematics
Downloaded by [Central Michigan University] at 00:57 12 December 2015
Series, Vol. 6, edited by N. Wagner, Financial Mathematics
Series. Boca Raton, FL: Chapman and Hall/CRC.
Campbell, J. Y., and G. B. Taksler. 2003. “Equity Volatility
and Corporate Bond Yields.” The Journal of Finance 58
(6): 2321–2350. doi:10.1046/j.1540-6261.2003.00607.x.
Caporin, M. 2013. “Equity and CDS Sector Indices: Dynamic
Models and Risk Hedging.” The North American Journal
of Economics and Finance 20: 261275. doi:10.1016/j.
najef.2012.06.004.
Cecchetti, S., P.-S. Lam, and N. Mark. 1990. “Mean Reversion
in Equilibrium Asset Prices.” American Economic Review
80: 398–418.
Christoffersen, P. F. 1998. “Evaluating Interval Forecasts.”
International Economic Review 39 (4): 841–862.
doi:10.2307/2527341.
Da Fonseca, J., and K. Gottschalk. 2011. “The Co-Movement
of Credit Default Swap Spreads, Stock Market Returns and
Volatilities: Evidence from Asia-Pacific Markets.”
Working Paper. Auckland: AUT Business School.
Da Fonseca, J., and K. Gottschalk. 2014. “Cross-Hedging
Strategies between CDS Spreads and Option Volatility dur-
ing Crises.” Journal of International Money and Finance 49
(B): 386–400. doi:10.1016/j.jimonfin.2014.03.010.
Diebold, F. X., and K. Yılmaz. 2014. “On the Network Topology
of Variance Decompositions: Measuring the Connectedness
of Financial Firms.” Journal of Econometrics 182 (1): 119–
134. doi:10.1016/j.jeconom.2014.04.012.
Duffie, D., and K. Singleton. 1999. “Modeling Term
Structures of Defaultable Bonds.” Review of Financial
Studies 12 (4): 687–720. doi:10.1093/rfs/12.4.687.
Ericsson, J., K. Jacobs, and R. Oviedo. 2009. “The
Determinants of Credit Default Swap Premia.” Journal of
Financial and Quantitative Analysis 44 (1): 109–132.
doi:10.1017/S0022109009090061.
Fenech, J., H. Vosgha, and S. Shafik. 2014. “Modelling the
Dependence Structures of Australian Itraxx CDS Index.”
Applied Economics 46 (4): 420–431. doi:10.1080/
00036846.2013.849378.
APPLIED ECONOMICS 17
Filipović, D., and A. B. Trolle. 2013. “Understanding
Liquidity and Credit Risks in the Financial Crisis.”
Journal of Financial Economics 109 (3): 707–733.
doi:10.1016/j.jfineco.2013.03.014.
Fujii, M., Y. Shimada, and A. Takahashi. 2010. “A Note on
Construction of Multiple Swap Curves with and without
Collateral.” Working paper SSRN-1440633. doi:10.2139/
ssrn.1440633.
Gefang, D., G. Koop, and S. M. Potter. 2011. “Understanding
Liquidity and Credit Risks in the Financial Crisis.” Journal
of Empirical Finance 18 (5): 903–914. doi:10.1016/j.
jempfin.2011.07.006.
Guo, F., C. R. Chen, and Y. S. Huang. 2011. “Markets
Contagion During Financial Crisis: A Regime-Switching
Approach.” International Review of Economics & Finance
20: 95–109. doi:10.1016/j.iref.2010.07.009.
Haas, M., S. Mittnik, and M. Paolella. 2004. “A New
Approach to Markov Switching GARCH Models.”
Journal of Financial Econometrics 2 (4): 493–530.
doi:10.1093/jjfinec/nbh020.
Hamilton, J. D. 1994. Time Series Analysis. Princeton, NJ:
Princeton University Press.
Hamilton, J. D., and G. Lin. 1996. “Stock Market Volatility
and the Business Cycle.” Journal of Applied Econometrics
11 (5): 573–593. doi:10.1002/(SICI)1099-1255(199609)
11:5<573::AID-JAE413>3.0.CO;2-T.
Hyun, J., N. Kang, and J. Kim. 2012. “The Lead-Lag
Relationships Among Stock Returns, Volatility Index
And Sovereign CDS Spreads In Korea Market.” Working
Paper. Seoul: KAIST Business School.
Ji, P. I. 2012. “Time-Varying Financial Stress Linkages:
Evidence from the LIBOR-OIS Spreads.” Journal of
International Financial Markets, Institutions and Money
22 (4): 647–657. doi:10.1016/j.intfin.2012.04.001.
Ji, P. I., and F. In. 2010. “The Impact of the Global Financial
Crisis on the Cross-Currency Linkage of LIBOR-OIS
Spreads.” Journal of International Financial Markets,
Institutions and Money 20 (5): 575–589. doi:10.1016/j.
intfin.2010.07.005.
Johannes, M., and S. Sundaresan. 2007. “The Impact of
Collateralization on Swap Rates.” The Journal of Finance
62 (1): 383–410. doi:10.1111/jofi.2007.62.issue-1.
Klaassen, F. 2002. “Improving GARCH Volatility Forecasts
with Regime-Switching GARCH.” Empirical Economics 27
(2): 363–394. doi:10.1007/s001810100100.
Krolzig, H.-M. 1997. “Markov-Switching Vector Autoregressions:
Modelling, Statistical Inference, and Application to Business
Cycle Analysis”. In Lecture Notes in Economics and
Mathematical Systems, Vol. 454. Berlin: Springer. doi:10.1007/
978-3-642-51684-9.
Liu, X., D. Margaritis, and P. Wang. 2012. “Stock Market
Volatility and Equity Returns: Evidence from a Two-State
Markov-Switching Model with Regressors.” Journal of
Empirical Finance 19 (4): 483–496. doi:10.1016/j.
jempfin.2012.04.011.
 18 J. DA FONSECA AND P. WANG
Mercurio, F. 2010. “LIBOR Market Model with Stochastic
Basis.” Working paper SSRN-1563685. doi:10.2139/
ssrn.1563685.
Merton, R. 1974. “On the Pricing of Corporate Debt: The
Risk Structure of Interest Rates.” Journal of Finance 29 (2):
449–470. doi:10.2307/2978814.
Michaud, F.-L., and C. Upper. 2008. “What Drives Interbank
Rates? Evidence From the Libor Panel.” BIS Quarterly
Review 47–58. http://ssrn.com/abstract=1517680
Naifar, N. 2012. “Modeling the Dependence Structure
between Default Risk Premium, Equity Return Volatility
and the Jump Risk: Evidence From a Financial Crisis.”
Economic Modelling 29 (2): 119–131. doi:10.1016/j.
econmod.2011.08.026.
Norden, L., and M. Weber. 2009. “The Co-movement
of Credit Default Swap, Bond and Stock Markets:
An Empirical Analysis.” European Financial
Downloaded by [Central Michigan University] at 00:57 12 December 2015
Management 15 (3): 529–562. doi:10.1111/j.1468-036X.
2007.00427.x.
Schaller, H., and S. Van Norden. 1997. “Regime Switching in
Stock Market Returns.” Applied Financial Economics 7 (2):
177–191. doi:10.1080/096031097333745.
Sola, M., and J. Driffill. 1994. “Testing the Term Structure of
Interest Rates Using a Stationary Vector Autoregression
with Regime Switching.” Journal of Economic Dynamics
and Control 18 (3–4): 601–628. doi:10.1016/0165-1889(94)
90025-6.
Turner, C., R. Startz, and C. Nelson. 1989. “A Markov Model
of Heteroskedasticity, Risk, and Learning in the Stock
Market.” Journal of Financial Economics 25 (1): 3–22.
doi:10.1016/0304-405X(89)90094-9.
Wang, A. T., and C. Yao. 2014. “Risks of Latin America
Sovereign Debts Before and After the Financial Crisis.”
Applied Economics 46 (14): 1665–1676. doi:10.1080/
00036846.2014.881976.
Wang, P., and R. Bhar. 2014. “Information Content in CDS
Spreads for Equity Returns.” Journal of International
Financial Markets, Institutions and Money 30: 55–80.
doi:10.1016/j.intfin.2014.01.005.
Williams, J. C., and J. B. Taylor. 2009. “A Black Swan in the
Money Market.” American Economic Journal:
Macroeconomics 1 (1): 58–83. doi:10.1257/mac.1.1.58.
Zhang, B. Y., H. Zhou, and H. Zhu. 2009. “Explaining Credit
Default Swap Spreads with the Equity Volatility and Jump
Risks of Individual Firms.” Review of Financial Studies 22
(12): 5099–5131. doi:10.1093/rfs/hhp004.
Zhou, Y. 2014. “Modeling the Joint Dynamics of Risk
Neutral Stock Index and Bond Yield Volatilities.” Journal
of Banking & Finance 38: 216–228. doi:10.1016/j.jbank
fin.2013.10.010.