In this paper, we propose a new indicator of euro stability. We make use of this new indicator and empirically investigate the impact of changes in sovereign risk of Eurozone member countries on the stability of the Euro. The stability of the Euro is proxied by decomposing Dollar-Euro exchange rate options into the moments of the risk-neutral distribution. Our stability measure can nicely separate periods of Dollar instability (the subprime crisis period) and Euro instability (the sovereign debt crisis period). In particular, we document that only during the sovereign debt crisis, changes in the creditworthiness of member countries with vulnerable fiscal positions have a significant impact on the stability of the common currency. Interestingly, however, the market perceives Greece not to be 'systemically relevant'. MotivationIn view of the sovereign debt crisis, understanding the dynamics of the credit risk of the Euro-area countries proves urgent so as to prevent dire scenarios. At worst, the default of a major country would unleash the currency break-up, ravage the European banking system and ultimately engender a global economic slump. In this study, we view the Eurozone sovereign debt crisis through the twin lenses of sovereign credit swaps and currency option markets. In the absence of Eurobonds, we empirically examine the impact of the credit risk of member countries on the stability of the Euro.The credit risk of a country can be measured through its sovereign credit default swap (CDS). Market prices of CDS spreads reflect the perception of financial markets about the economic-political stability of a country, and thus about the creditworthiness of a given sovereign. As shown by Pan and Singleton (2008), the changes in credit risk premiums of sovereign markets which translate into changes in sovereign CDS spreads, do not emanate from changes in fundamentals of the underlying economies. Rather, these variations mirror a change in the risk appetite of market participants in terms of credit exposure. A negative change in the creditworthiness of a sovereign inevitably translates into a depreciation of its currency along with soaring currency volatility. Furthermore, currency option prices are instruments which are capable of predicting the changes in the realized volatility of currency returns. Based on data from the Mexican and Brazilian Markets, Car and Wu (2007) establish a relationship between sovereign CDS spreads and currency return A C C E P T E D M A N U S C R I P T ACCEPTED MANUSCRIPT3 volatilities induced through implied-volatilities of currency options and risk reversals 1 .Their results indicate that the sovereign CDS spreads covary substantially with the risk reversals. In the same spirit, Hui and Fong (2011) report similar results while focusing on the interconnectivity between the US and Japan sovereign CDS markets and the currency option market characterized by risk reversals of options on the Dollar-yen exchange rate.Compared to Japan, The US sovereign credit risk is shown to have a significan...
Purpose – This paper aims to investigate informational efficiency of stock, options and credit default swap (CDS) markets. Previous research suggests that informed traders prefer equity option and CDS markets over stock markets to exploit their informational advantage. As a result, equity and credit derivative markets contribute more to price discovery compared to stock markets. Design/methodology/approach – In this study, the authors investigate the dynamics behind informed investors’ trading decisions in European stock, options and CDS markets. This allows to identify the predictive explanatory power of the unique information contained in each market with respect to future stock, CDS and option market movements. Findings – A lead-lag relation is found between the CDS market and the other markets, in which changes in CDS spreads are able to consistently forecast changes in stock prices and equity options’ implied volatilities, indicating how the fast-growing CDS market seems to play a special role in the price discovery process. Moreover, in contrast to results of US studies, the stock market is found to forecast changes in the other two markets, suggesting that investors also prefer stock market involvement to exploit their information advantages before moving to CDS and option markets. Interestingly, these patterns have only emerged during the recent financial crisis, while before the crisis, the option market was found to be of major importance in the price discovery process. Originality/value – The authors are the first to study the lead-lag relationship among European stock, option and CDS markets for a large sample period covering the financial crisis.
In this study, we investigate the dynamics behind informed investors' trading decisions among European stock, options and credit default swap markets. This allows us to identify the predictive explanatory power of the unique information contained in each market with respect to future stock, CDS and option market movements. A lead-lag relation is found between the CDS market and the other markets, in which changes in CDS spreads are able to consistently forecast changes in stock prices and equity options' implied volatilities pointing out how the fast growing CDS market seems to play a special role in the price discovery process. Moreover, in contrast to US results, the stock market is found to forecast changes in the other two markets suggesting that investors also prefer stock market involvement to exploit their information advantages and then move to CDS and option markets. Interestingly, those patterns have only emerged during the recent financial crisis, while before the crisis the option market was found to be of major importance in the price discovery process. AbstractIn this study, we investigate the dynamics behind informed investors' trading decisions among European stock, options and credit default swap markets. This allows us to identify the predictive explanatory power of the unique information contained in each market with respect to future stock, CDS and option market movements. A lead-lag relation is found between the CDS market and the other markets, in which changes in CDS spreads are able to consistently forecast changes in stock prices and equity options' implied volatilities pointing out how the fast growing CDS market seems to play a special role in the price discovery process. Moreover, in contrast to US results, the stock market is found to forecast changes in the other two markets suggesting that investors also prefer stock market involvement to exploit their information advantages and then move to CDS and option markets. Interestingly, those patterns have only emerged during the recent financial crisis, while before the crisis the option market was found to be of major importance in the price discovery process. AbstractIn this study, we investigate the dynamics behind informed investors' trading decisions among European stock, options and credit default swap markets. This allows us to identify the predictive explanatory power of the unique information contained in each market with respect to future stock, CDS and option market movements. A lead-lag relation is found between the CDS market and the other markets in which changes in CDS spreads are able to consistently forecast changes in stock prices and equity options' implied volatilities pointing out how the fast growing CDS market seems to play a special role in the price discovery process. Moreover, in contrast to US results, the stock market is found to forecast changes in the other two markets suggesting that investors also prefer stock market involvement to exploit their information advantages and then move to CDS and option markets...
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