Brexit and CDS spillovers across UK and Europe

Abstract

Understanding the transmission process between markets is critical for risk management and economic policy. The objective of this paper is twofold. First, it identifies when UK and European (France, Germany, Italy and Spain) Credit Default Swaps (CDSs) exhibit explosivity with respect to their past behaviors. Second, it quantifies the dynamics of CDS volatility spillover effects surrounding the UK's EU membership referendum commonly known as " Brexit ". Using a recursive identification algorithm and new spillover measures suggested by Diebold and Yilmaz (2012), quite interesting results were drawn. We detect significant build-ups in CDS prices for all countries under study soon after the day relative to the announcement of Brexit. Besides, we show that the great uncertainty over Brexit generates significant volatility spillovers across the underlined CDS. In particular, we find that UK, Italy and Spain are the " net volatility transmitters " , while France and Germany seem the " net volatility receivers ". Such information can help policy makers in undertaking decoupling policies to (1) insulate the economy from risk spillovers effects, (2) lighten the spread of the damage done by Brexit and (3) preserve the stability of financial system. To attenuate the risk transmission across CDS markets over Brexit, regulators can, for example, put forth preventive strategies by foregrounding the most influential volatility senders (UK, Italy and Spain).