SUPPORTED BY UNIGESTION Dynamic Dependence and Diversification in Corporate Credit

We characterize dependence and tail dependence in corporate credit using a new class of dynamic copula models which can capture dynamic dependence and asymmetry in large samples of firms. We also document important differences between the dependence dynamics for credit spreads and equity returns. Modeling a decade of weekly CDS spreads for 215 firms, we find that copula correlations are highly time-varying and persistent, and that they increase significantly in the financial crisis and have remained high since. Perhaps most importantly, tail dependence of CDS spreads increases even more than copula correlations during the crisis and remains high as well. The most important shocks to credit dependence occur in August of 2007 and in August of 2011, but interestingly these dates are not associated with significant changes to median credit spreads. The decrease in diversification potential caused by the increase in dependence and tail dependence is large. Finally, we find that the CDS volatility, correlation and tail dependence measures that we have constructed using the dynamic copula model are important determinants of credit spreads over time. Monday, May 5, 2014, 10:30-12:00 Room 125, Extranef building at the University of Lausanne Dynamic Dependence and Diversi cation in Corporate Credit Peter Christo¤ersen Kris Jacobs University of Toronto, University of Houston CBS, and CREATES and Tilburg University Xisong Jin Hugues Langlois University of Luxembourg McGill University December 20, 2013 Abstract We characterize dependence and tail dependence in corporate credit using a new class of dynamic copula models which can capture dynamic dependence and asymmetry in large samples of rms. We also document important di¤erences between the dependence dynamics for credit spreads and equity returns. Modeling a decade of weekly CDS spreads for 215 rms, we nd that copula correlations are highly time-varying and persistent, and that they increase signi cantly in the nancial crisis and have remained high since. Perhaps most importantly, tail dependence of CDS spreads increases even more than copula correlations during the crisis and remains high as well. The most important shocks to credit dependence occur in August of 2007 and in August of 2011, but interestingly these dates are not associated with signi cant changes to median credit spreads. The decrease in diversi cation potential caused by the increase in dependence and tail dependence is large. Finally, we nd that the CDS volatility, correlation and tail dependence measures that we have constructed using the dynamic copula model are important determinants of credit spreads over time. JEL Classi cation: G12 Keywords: credit risk; default risk; CDS; dynamic dependence; copula.We characterize dependence and tail dependence in corporate credit using a new class of dynamic copula models which can capture dynamic dependence and asymmetry in large samples of rms. We also document important di¤erences between the dependence dynamics for credit spreads and equity returns. Modeling a decade of weekly CDS spreads for 215 rms, we nd that copula correlations are highly time-varying and persistent, and that they increase signi cantly in the nancial crisis and have remained high since. Perhaps most importantly, tail dependence of CDS spreads increases even more than copula correlations during the crisis and remains high as well. The most important shocks to credit dependence occur in August of 2007 and in August of 2011, but interestingly these dates are not associated with signi cant changes to median credit spreads. The decrease in diversi cation potential caused by the increase in dependence and tail dependence is large. Finally, we nd that the CDS volatility, correlation and tail dependence measures that we have constructed using the dynamic copula model are important determinants of credit spreads over time. JEL Classi cation: G12