A Markov switching unobserved component analysis of the CDX index term premium

Abstract

Using a Markov switching unobserved component model we decompose the term premium of the North American CDX index into a permanent and a stationary component. We establish that the inversion of the CDX term premium is induced by sudden changes in the unobserved stationary component, which represents the evolution of the fundamentals underpinning the probability of default in the economy. We find evidence that the monetary policy response from the Fed during the crisis period was effective in reducing the volatility of the term premium. We also show that equity returns make a substantial contribution to the term premium over the entire sample period.

Publication DOI: https://doi.org/10.1016/j.irfa.2016.01.020
Divisions: Aston Business School
Additional Information: © 2016, Elsevier. Licensed under the Creative Commons Attribution-NonCommercial-NoDerivatives 4.0 International http://creativecommons.org/licenses/by-nc-nd/4.0/
Uncontrolled Keywords: CDX index,Markov switching,state space variance decomposition,term premium
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Related URLs: https://www.sci ... 0060?via%3Dihub (Publisher URL)
PURE Output Type: Article
Published Date: 2016-03
Published Online Date: 2016-02-16
Accepted Date: 2016-01-25
Submitted Date: 2015-07-27
Authors: Calice, Giovanni
Ioannidis, Christos
Miao, RongHui

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