The Age of Turbulence, Credit Derivatives Style. Hans NE Byström Lund University. The paper focuses on. the many extreme credit default swap spread movements observed during the credit crisis 2007-08
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Hans NE Byström
“Although the General Motors episode [of 2005] might not repeat itself, it should nonetheless be a lesson for the future; whether or not the credit environment becomes riskier over the next couple of years, similar sudden changes in CDS spreads most likely will strike the CDS index market from time to time.”
This was written in 2006 (i.e. well before the credit crisis) and today few would argue against the importance of an explicit focus on low-probability tail events!
During the crisis, many CDS index spread changes are larger than +/-10%:
During the 8-month crisis period there are 11 daily spread changes that are larger than +10% and 6 daily spread changes that are larger than -10%. Meanwhile, during the four times longer pre-crisis period there are only 1 spread change that is larger than +10% and 2 spread changes that are larger than -10%.
During the crisis, many CDS index spread changes are much larger than the largest spread changes ever seen before the crisis.
During the 8-month short crisis period, a total of 3(6) positive (negative) daily spread changes are larger than any spread change seen during the 36-month long pre-crisis period. Moreover, 18 (7) spread changes are larger than the second-largest spread change ever observed before the crisis.
During the crisis, the most extreme CDS index spread changes are very large.
The most extreme daily spread changes during the crisis are +/-26%.
A comparison of multi-sigma events in the credit derivatives market and in the stock market reveals large differences
The largest daily spread changes during the crisis represent spread movements of more than 13 (pre-crisis) standard deviations. If we had seen one or two daily S&P500 stock returns of the same magnitude (i.e., 13-sigma events) during the crisis months they would have been around +/-9%.
Out of the first 30 days of the credit crisis, every second day sees a 5-sigma, or larger, CDS index spread change
Over the first month (22 trading days) of the credit crisis 11 daily spread changes are larger than +/-5 standard deviations. The corresponding return history in the US stock market (S&P500) would be -9.1%, -6.5%, -4.1%,-3.9%, -3.4%, 3.4%, 3.6%, 4.3%, 5.5%, 7.4% and 8.6%. And that is in July only!
The cost of insuring corporate debt against default in the iTraxx Europe CDS index market has increased eight-fold since the start of the crisis.
In mid-June 2007, the cost of insuring corporate debt in Europe against default hit a low-point at about 20bp. Since then, the cost has gone up eightfold to reach a high of 160bp in mid-March 2008 (never before in the history of the iTraxx indexes has one observed costs above 60bp.)
VaRp = u +α/ξ[(n∙p/Nu)-ξ − 1]
where n is the total number of spread changes in the data set and
Nu is the number of spread changes above the threshold u.