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Keywords

fi nancial stability; European banks; distance-to-default; credit default swap; lead-lag relationship

Abstract

CDS spreads are often seen as the ’leading’ market based, default risk measure. There is no popular alternative to CDS spreads except perhaps for the distance-to-default (D2D) measure based on Merton (1974), which comes very close to it. In this paper, we investigate the correlation and short-term dynamics between these two measures for large European banks with a data panel spanning from 1/2006 to 12/2013. The analysis makes use of conventional Granger causality test statistics for individual banks and for the whole panel data. As regards the results, we found that the lead-lag relationship between these highly related variables varies over time, over different banks, and over economic regimes. The lead of D2D is significantly stronger for banks that are smaller relative to the other banks in the sample, banks in problem countries (PIIGS), after global financial crises, during market turmoil, and for banks with poor credit quality indicated by a high CDS spread. These results and the fact that D2D can be calculated for every bank quoted on the stock exchange suggests that D2D is a promising alternative to the CDS spread in default risk assessment of banks.

Acknowledgments

We would like to thank Matti Viren, Heikki Kauppi and Erik Mäkelä for valuable comments during the research and Susmita Baulia for providing proofreading. Also thank you for the anonymous referees for the good comments and the TOP-foundation for fi nancial support.

First Page

121

Last Page

143

Page Count

143

Received Date

University of Warsaw

Revised Date

24 January 2016

Accept Date

3 April 2016

Online Available Date

27 April 2016

DOI

10.7172/2353-6845.jbfe.2016.1.5

JEL Code

G01; G21; G32

Publisher

27 April 2016

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