Credit derivatives: instruments of hedging and factors of instability. The example of ?Credit Default Swaps? on French reference entities

TL;DR

This study analyzes the interconnectedness of French credit default swaps, shares, and bonds from 2001 to 2008, highlighting how CDS can contribute to financial instability during market tensions.

Contribution

It provides an empirical analysis of the interdependence between CDS, shares, and bonds, illustrating how credit derivatives can heighten market instability.

Findings

Strong interdependence between markets, especially during crises

Share market significantly influences CDS and bond spreads

Market tensions amplify interdependence effects

Abstract

Through a long-period analysis of the inter-temporal relations between the French markets for credit default swaps (CDS), shares and bonds between 2001 and 2008, this article shows how a financial innovation like CDS could heighten financial instability. After describing the operating principles of credit derivatives in general and CDS in particular, we construct two difference VAR models on the series: the share return rates, the variation in bond spreads and the variation in CDS spreads for thirteen French companies, with the aim of bringing to light the relations between these three markets. According to these models, there is indeed an interdependence between the French share, CDS and bond markets, with a strong influence of the share market on the other two. This interdependence increases during periods of tension on the markets (2001-2002, and since the summer of 2007).