Dependence in Credit Default Swap and Equity Markets : Dynamic Copula with Markov-Switching

Theoretical credit risk models a la Merton (1974) predict a non-linear negative link between a firm's default likelihood and asset value. This motivates us to propose a flexible empirical Markov-switching bivariate copula that allows for distinct time-varying dependence between credit default swap (CDS) spreads and equity prices in “crisis” and “tranquil” periods. The model identifies high dependence regimes that coincide with the recent credit crunch and the European sovereign debt crises, and is supported by in-sample goodness of fit criteria versus nested copula models that impose within-regime constant dependence or no regime-switching. Value at Risk forecasts to set day-ahead trading limits for hedging CDS-equity portfolios reveal the economic relevance of the model from the viewpoint of both regulatory and asymmetric piecewise linear loss functions