provided by Research Papers in Economics
Journal of Applied Economic Sciences
Volume IV/ Issue 1(7)/ Spring 2009
CAN CREDIT DEFAULT SWAPS PREDICT FINANCIAL CRISES?
EMPIRICAL STUDY ON EMERGING MARKETS
Hekuran NEZIRI
American University, Bulgaria
Abstract:
We explore the informational value of credit default swaps and the extent to which they may be linked to
financial crises. After developing a theoretical framework to model the relationship between credit default swap
market and equity and currency markets, we apply an empirical study which uses logistic regressions and a
panel data sample of emerging markets to assess the ability of these financial instruments to predict crises.
Regarding them as reflections of future expectations of investors on the outcomes of currency and equity
markets, we find credit default swaps to be a significant indicator explaining the periods proceeding financial
crises, at least in equity markets. The inclusion of credit default swaps as a factor in models that predict crises
and their ability to improve predictions in equity market is a major contribution of this study to the existing
literature.
Keywords: credit default swaps, stock market crises, currency crises, emerging market debt
JEL Classification: F3
1. Introduction
Credit default swaps have been all around the news on the current financial crisis. Economists,
investors, politicians and almost everyone seemed to agree that these financial instruments contain
important information that can be used to gauge the financial situation during the current financial
crisis. An article in Wall Street Journal on Oct 31, 2008 reports:
Investors raise their bets on defaults in EU Countries implying that euro-zone economy heads
into recession as costly bank-bailout plans could drive some European governments to default on their
debt. Soaring (credit default) swap prices have preceded real calamity. Investor fears about the health
of Wall Street firms like Bear Stern Cos. And Lehman Brothers Holding Inc. appeared in swap prices
early on and contributed to capital flights that left the firms seeking government help. Credit default
swaps have proven themselves a reliable indicator of trouble ahead.
However, can we say that an increase in credit default swap prices implies trouble in the near
future for the reference entity? This question prompted us to explore the informational value of credit
default swaps and the extent to which they may be linked to financial crises. Specifically, we
investigate the ability of fluctuations in these premiums to predict the occurrence of financial crises.
The analysis explores the ability of credit default swaps to predict stock market and currency
market crises. The hypothesis is that CDS premiums reflect future expectations of investors on
outcomes in currency and equity markets. The premium allows for a clear view of investor perception
of risk. Logistic models with panel data from emerging markets are used to assess the crises predictive
power of premiums written on sovereign obligations of emerging markets. We check the effect on
both stock and currency markets.
To our knowledge, this is the first paper to use credit default swap premiums in predicting
financial crises. However, other factors which were created to reflect investor sentiment have been
previously used. In principle financial crises should be preceded by periods of increased risk aversion
among investors. Curdert and Gex (2007) test whether some main risk aversion indexes are able to
predict crises. They find that “risk appetite” tends to decrease prior to financial crises. Also, they do
not fail to mention that the opposite case is possible. Crises may follow after periods of strong “risk
appetite” during which investors are excessively optimistic and hence create “speculative bubbles” on
the prices of risky assets. The recent mortgage crisis is an example of increased investor “risk
appetite” prior to crises. According to their findings, risk aversion indicators had more predictive
ability in stock market crises then currency crises.
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