XXV Edition

1-2 December 2016"

Portfolio Enhancement via Credit Default Swap Indices - Evidence from North America and Europe

Hippert Benjamin, University of Paderborn
Wengerek Sascha Tobias, University of Paderborn

In the last decade financial markets were characterized by serious distortions, rising interconnectedness across individual asset classes and high level of uncertainty. Therefore, portfolio managers faced the challenge to design investment portfolios consisting of different asset classes with adequate risk-return properties, especially with low downside risk sensitivity. The advantages of CDS in cross-asset comparison have been emphasized in several recent studies. Accordingly, we recap the existing literature and extend the results to portfolio considerations. Moreover, our paper analyzes the diversification contribution of the addition of individual CDS indices for American and European investors. The in- and out-of-sample mean-variance analyses are conducted over the sample period from 2006-2014 as well as over different subperiods (pre-crisis, crisis and post-crisis) to obtain more detailed results in dependence of different economic surroundings. Based on stock, government bond and CDS index excess returns, the empirical investigation examines the diversification gains of CDS indices on varied risk types of investors (conservative vs. aggressive) separately. The obtained results indicate a significant improvement of investors' opportunity set by the incorporation of CDS indices. Particularly, the portfolio risk reduction potential is recognizable in almost each period. Furthermore, it is striking that by the addition of a CDS index, the government bond index is mainly displaced. However, the results also suggest that CDS indices are not a safe-haven instrument, due to high correlation dependencies with stock markets and a certain vulnerability in the financial crisis. The results are confirmed by the implementation of several robustness checks and sensitivity analyses.

Area: Young Economists Session (YES award)

Keywords: credit default swap indices, mean-variance asset allocation, out-of-sample portfolio optimization, diversification, performance evaluation, credit risk investment

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