Brexit and CDS spillovers across UK and Europe.

• Author: Bouoiyour, Jamal

1. Introduction

   In the wake of the UK vote to leave the European Union (EU), capital markets face a period of great uncertainty with unknown consequences. Notably, the cost of buying protection against a default on British sovereign debt using Credit Default Swaps (hereafter, CDS) widened to a three-year high following the week's vote to withdraw the EU. Thomson Reuters indicates that CDS cost now $48,500 a year to protect $10 million of U.K. sovereign debt for five years, compared with levels near $32,000 prior to the June 23rd referendum. In addition, the credit risk increased in a number of European countries. France experienced a rise of its five-years CDS spread by about 49% (with less extent Germany by approximately 31%). Peripheral Europe, Italy and Spain saw their five-years CDS spread widen 24% and 25%, respectively. The sharp growth in CDS means that the latter has become crucial to help investors and traders to avoid credit risks. Compared to corporate bond spread, CDS spread were often viewed as a good proxy of inherited credit risk (Forte and Levreta 2009); it provides "insurance" against a credit event that might destroy value in a corporation's or a financial institution's debt (Berndt et al. 2007). In addition, CDS markets incorporate new information more quickly than bonds (Blanco et al. 2005; Zhu 2006; Bouoiyour et al. 2016). Interestingly, the credit default swap contracts have made a big impact recently in the financial crisis. Even though they may not be the cause of the crisis, they contributed largely to spread distress across companies and financial institutions (for example, Acharya and Johnson 2007; Saygun 2014). In light of the deepest fluctuations of CDS over the last two years, a better understanding of the interconnectedness among UK and European (in particular, France, Germany, Italy and Spain) (1) CDS spreads may be very useful.

   Our assessment contributes to existing research in several aspects. First, we do not impose any structural breakpoint and reach beyond the comparison of selected periods (for instance, prior to and post the Brexit vote) towards the examination of gradual structural change. Accurately, using CDS spreads as proxy of credit risk, this paper sets out to capture periods of explosive behavior of UK and EU CDS spreads. For empirical purpose, we carry out a generalized sup ADF (GSADF) test procedure proposed by Phillips, et al. (2013) aimed at identifying stable and bubble-episodes in the investigated time series. Second, during crises a prominent topic discussed by academics, regulators and market participants in general is that of spillovers. This research attempts to investigate volatility linkages between UK and European CDS spreads, which remain up to now not researched over Brexit looms. To provide reliable information about CDS risk spillovers and to take efficient policy actions, there is a need for effective measures. This study conducts a generalized VAR in variance decomposition developed by Diebold and Yilamz (2012) to measure the total volatility spillover effects, and to shed some light on the net directional spillovers among UK and European CDS spreads. We should mention that relatively few empirical researches have examined the dynamic volatility spillovers across CDS indexes in European countries (Alter and Beyer 2013; Heinz 2014; Alemany 2015). By combining ARMA-FIGARCH skewed Student-t distribution as measure of volatility and Diebold and Yilamz (2012)' procedure, we carry out a full-sample spillover analysis and a rolling-sample analysis allowing for time-varying spillovers.

   With the increased Brexit fears, we capture explosive periods in the prices of UK and European CDS with respect their past attitudes with the onset of the Brexit vote. Besides, we show that the uncertainty over UK's EU membership withdrawal resulted in significant volatility spillover effects across UK and EU CDS. Specifically, UK, Italy and Spain are the stress volatility exporters, whereas France and Germany are the net receivers of volatility spillovers. The structure of the article is as follows: Section 2 includes a brief discussion of the theory. Section 3 presents a description of the data used along with the methodology followed, while Section 4 reports the main empirical results. Section 5 looks at their robustness. Section 6 concludes.

2. Theoretical Considerations

   The past several years have witnessed noticeable research concerning how CDS risk spillovers across countries become wider during turbulent times, and much has been written on both the theoretical and empirical sides of the issue. Specifically, the credit default swap contracts have made a big impact recently in the financial crisis. Even though they may not be the cause of the crisis, they contributed largely to spread distress across companies and financial institutions (Saygun 2014).

   Some works assessed the response of CDS spreads to credit events over the last decade, by concentrating on cross-border spillover effects, addressing whether the effect of rating events extends to other countries beyond the respective economy.

   Accordingly, Caporin et al. (2012) analyzed the sovereign risk spillovers within the euro area. They concluded that the common shift in CDS spreads is the outcome of the usual interconnection and that the strength in the transmission mechanism has not changed over the global financial collapse. Besides, by analyzing sovereign CDS spreads in the US and Europe, Ang and Longstaff (2011) claimed that systemic sovereign risk seems strongly associated to financial markets than to country-specific macro-features. Additionally, Beirne and Fratzscher (2012) showed that global financial markets (in particular, CDS markets) are more affected by economic fundamentals during turbulent rather than tranquil times. Nevertheless, they demonstrated that regional spillovers are less able to explain risks. Ejsing and Lemke (2011) empirically gauged the dynamic dependencies across CDS spreads of European countries and banks with a common risk factor and find that sovereign CDS indexes are likely to be more vulnerable to the common risk factor than banks' CDS spreads. Likewise, Kalbaska and Gatwoski (2012) investigated contagion among several European CDS markets. They corroborated that countries under distress (including Greece, Ireland, Portugal, Spain and Italy) tend to trigger slight contagion across the Euro area countries. Claeys and Vasicek (2012) carried out different spillover measures following Diebold and Yilmaz (2012)'s procedure for a sample of EU sovereign bond and CDS spreads. They concluded that the return and volatility spillover among sovereign yields and CDS rose substantially since 2007 but their strength is not uniform across the investigated countries. Also, Alter and Schuler (2012) argued for contagion from banks to sovereign CDS prior to the achievement of public rescue programs for the financial sector, while sovereign CDS spreads do spill over to bank CDS series thereafter. Moreover, Gande and Parsley (2005), Ferreira and Gama (2007) and Afonso et al. (2012) evaluated the cross-border effect of sovereign credit ratings on international sovereign bond spreads and stocks and European sovereign bond and CDS spreads. All these studies deeply suggested the occurrence of asymmetric spillovers, with the impact of downgrades being the most influential. Boninghausen and Zabel (2015) sustained the previous evidences, by examining the influence of sovereign rating events on international sovereign bond market. They argued that such impact is more pronounced for countries within the same region. Furthermore, Wengner et al. (2015) explored the impact of rating events on the CDS spreads for both the event and non-event companies. They indicated that there exist significant risk spillover effects across the major competitors. More recently, Apergis et al. (2016), using Diebold and Yilmaz (2012) total spillover index as the dependent variable, showed quite interesting findings with respect the the impact of newswire messages on intensity of spillovers across CDS spreads. In particular, they showed that the news variable generates significant spillover effects among the underlined GIIPS CDS markets during the European debt crisis.

   The research complements the existing literature by analyzing the role that may play the Brexit fears in exacerbating the risk spillovers among UK and European CDS spreads. We investigate not only the effect over the dayrelative to the Brexit announcement; rather investigates the spillover effects prior to and after the decision of the UK' EU referendum.

3. Methodology and data

   To properly measure the risk spillovers among UK and European CDS spreads, we conduct a three-stage empirical methodology. First, we analyze the behaviors of UK and European CDS spreads over Brexit via a novel econometric technique developed by Phillips et al. (2013), dubbed the generalized form of the SADF (GSADF). This technique is suited to capture the stable- and bubble-periods in time series. Second, we analyze the descriptive statistics of the conditional variances, and search for...