Evaluating the Relationship Between Credit Default Swaps and Systemic Financial Risk During Market Turbulence

Posted: Aug 30, 2022

• Jacob Scott
• James Gonzalez
• James Perez

Abstract

The global financial system has experienced significant turbulence over the past two decades, with credit default swaps (CDS) playing an increasingly prominent role in both risk transfer and systemic vulnerability. These financial instruments, designed initially as insurance against credit events, have evolved into complex vehicles that simultaneously measure and influence financial stability. The relationship between CDS markets and systemic risk represents a critical area of inquiry, particularly given the dual nature of CDS as both risk indicators and potential risk amplifiers during periods of market stress. Traditional financial literature has approached CDS markets through relatively static frameworks, often treating them as either leading indicators of credit quality or as contributors to financial contagion. However, these perspectives fail to capture the dynamic and context-dependent nature of CDS relationships with systemic risk. During calm market periods, CDS spreads typically reflect fundamental credit risk assessments, serving as valuable pricing mechanisms. Yet during turbulent episodes, the same instruments can transform into transmission channels for financial distress, amplifying rather than merely reflecting systemic vulnerabilities. This research addresses several critical gaps in the existing literature. First, we develop a novel methodological framework that accounts for the regime-dependent nature of CDS-systemic risk relationships. Second, we introduce a multi-layer network approach that captures the complex interconnections between CDS markets, equity markets, and interbank lending networks. Third, we employ advanced analytical techniques including wavelet coherence analysis.