Explaining Credit Default Swap Spreads by Means of Realized Jumps and Volatilities in the Energy Market

This paper studies the relationship between credit default swap spreads (CDS) for the Energy sector and oil futures dynamics. Using data on light sweet crude oil futures from 2004 to 2013, which contains a crisis period, we examine the importance of volatility and jumps extracted from the futures in explaining CDS spread changes. The analysis is performed at an index level and by rating group; as well as for the pre-crisis, crisis and post-crisis periods. Our findings are consistent with Merton’s theoretical framework. At an index level, futures’ jumps are important when explaining CDS spread changes, with negative jumps having higher impact during the crisis. The continuous volatility part is significant and positive indicating that futures volatility conveys relevant information for the CDS market. As for the analysis per rating group, negative jumps have an increasing importance as the credit rating deteriorates, and during the crisis period; while the results for positive jumps and futures volatility are mixed. Overall, the relation between the CDS market and the futures market is stronger during volatile periods and strengthens after the Global Financial Crisis. JEL Classification: G12, G13, C14