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Journal of Banking & Finance Vol. 37 No. 9 2013

Option-implied correlation between iTraxx Europe Financials and Non-Financials Indexes: A measure of spillover effect in European debt crisis

Cho-Hoi Hui1; Chi-Fai Lo2,3; Chun-Sing Lau3,2

1 Research Department, Hong Kong Monetary Authority, 55/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong, China · 2 Institute of Theoretical Physics · 3 Chinese University of Hong Kong

Abstract

This paper proposes an analytic method to estimate the option-implied correlation embedded in options on the iTraxx Europe CDS indexes. The option-implied correlation is suggested as a measure of the spillover effect of default risk between the financial and corporate sectors in Europe. In particular, the correlation between the iTraxx Financials and Non-Financials sub-indexes is estimated from options on the iTraxx Main Index, which is considered as a basket option with the two sub-indexes being its underlyings. The abrupt changes of the realized correlation anticipated information of the corresponding option prices. The sovereign default risk, funding liquidity risk, level of risk aversion, and equity market performance are identified to be significant determinants of the option-implied correlation, implying inter-dependence amongst various markets during the European debt crisis.

DOI
10.1016/j.jbankfin.2013.05.030
Volume
37
Issue
9
Pages
3694-3703
Language
en
Sources
openalex crossref bibtex:phds-export.bib

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