Sovereign Risk, Cross-Currency Basis and Equity Markets: A Cross-Market Dynamic Interaction

Abstract

To explore the propagation of shocks across markets, this paper examines the dynamic connections between three distinct markets: credit default swaps (CDS), equities, and cross-currency basis swaps (CCBS) of four major individual economies: Eurozone, UK, Australia, and Japan. We use CDS spreads, CCBS spreads and stock market returns to capture sovereign credit risk, dollar funding liquidity and stock market performance, respectively. Our results show there is a feedback mechanism connecting these markets, for most of these economies. We document that higher CDS spreads induce wider CCBS spreads and declines in stock market returns. We equally show that positive shocks to CCBS spreads lessen CDS spreads and enhance stock market returns. Finally, we show that positive shocks to the stock market are associated with lower CDS spreads and tighter CCBS spreads. These findings are supported by Granger-causality analysis and are robust across subperiods and empirical specifications. Underpinning the feedback mechanism is the role of CDS as an indicator of potential default on obligations in the financial markets.