Discussion Paper

No. 2013-52 | September 30, 2013
Tail Dependence of Financial Stocks and CDS Markets – Evidence Using Copula Methods and Simulation-Based Inference


Using copula methods and simulation-based inference the authors address the association between the performance of the stocks of European banks and the CDS markets. Their analysis has three purposes: (i) analysing the dependence structure of the markets when extreme events occur; (ii) checking the validity of the conclusion of Merton (On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, 1974) and other similar structural models concerning the intensification of the relationship between stock prices and credit spreads during financial distress periods; (iii) analysing the auto-covariance of the dependence structure. First, the results show symmetric dependence and tail dependency equality between the two markets. This means that, surprisingly, the association between stock prices and spreads of the banking sector does not seem to surge in financial distress periods, contradicting the conclusions of Merton (1974) and other structural models, which could be related with a “too-big-to-fail” effect. Second, the authors do not detect structural breaks in the dependence structure in a period marked by the U.S. financial crisis (2008) and the European sovereign debt crisis (2010), which posed concerns on the European financial system health. Finally, they find evidence that the dependence between the markets is autoregressive and possibly time variant. The authors suggest that the inexistence of a higher negative tail dependence between the filtered returns may reside in the “too-big-to fail” effect, that is, credit holders receive a subsidy from governments protecting them from bankruptcy costs, contrary to what happens with equity holders whose capital is wiped-out if the bank fails.

Data Set

JEL Classification:

G13, G14, G15


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Cite As

Paulo Pereira da Silva, Paulo Tomaz Rebelo, and Cristina Afonso (2013). Tail Dependence of Financial Stocks and CDS Markets – Evidence Using Copula Methods and Simulation-Based Inference. Economics Discussion Papers, No 2013-52, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2013-52

Comments and Questions

Anonymous - Recommended
October 07, 2013 - 18:34

Good paper.

Paulo Horta - Invited Reader Comment
November 06, 2013 - 10:38

see attached file

Paulo Pereira da Silva - Dear Profº Paulo Horta,
March 17, 2014 - 10:18

First of all, I would like to thank you for your comments and advices. Regarding the first issue, there is no data available prior to 2007 for the CDS index (it started precisely in 2007).
We consider that the proposed exercise could be useful to infer about the stability ...[more]

... of the estimated coefficients, albeit not crucial to the conclusions because other stability tests are performed in the analysis. Besides, the copula structure accommodates the common reaction of the markets during good and bad times. In effect, we are indeed testing if the tail risk is equal in good and bad states.
In terms of the points 2, 3, 5, we agree with your comments and we will provide further explanations and economic intuition to the results. All the minor comments will also be taken into account.

Best regards,
Paulo Pereira da Silva
Paulo Rebelo
Cristina Afonso

Anonymous - Referee Report 1
February 10, 2014 - 09:48

see attached file

Paulo Pereira da Silva, Paulo Rebelo, Cristina Afonso - Reply to Referee Report 1
July 30, 2014 - 14:13

See attached file

Paulo Pereira da Silva, Paulo Rebelo, Cristina Afonso - Revised Version
July 30, 2014 - 14:19

See attached file