Credit risk downgrades and the CDS market: a wavelet analysis

Abstract

PurposeThis paper aims to assess the consequences of credit risk downgrades on credit default swaps (hereafter CDS) written on financial companies from two different perspectives, namely the overall stress level observed on the market and the rating agency performing the downgrade.Design/methodology/approachThe authors' study relies on several wavelet analyses performed on different subsamples of data coming from the iTraxx index, the downgrade dates ranging between October 28, 2005 and February 3, 2015. This study highlights that both the overall stress level and the rating agency taking actions do have an influence on how market players will react.FindingsThe authors' study points out that market players will anticipate and react to downgrades in different ways depending on the level of stress. Feedback effects are observed after the downgrade only during periods of tension. From a rating agency point of view, the authors' study shows that the market share as well as the reputation of each agency have an influence on the aftermaths of a downgrade.Originality/valueTo the authors' knowledge, this paper is the first one relying on wavelet to analyse the consequences of a downgrade on CDS market. The use of this methodology allows to capture the multiple impacts of a downgrade through time and, therefore, to analyse the dynamics triggered on the market by a negative rating event. Moreover, the study of the downgrades' repercussions of each of the main rating agencies underlines a psychological dimension in the way market players react to a downgrade.