Tail Risk in Credit Markets: A Dynamic Power-Law Model

I provide a measure of time-varying tail risk in credit markets based on a dynamic power-law model. Credit tail risk is estimated from extreme price fluctuations of credit default swaps (CDS) on government debt. Tail returns are described by a power-law for core and peripheral countries within the Economic and Monetary Union. I find that the tail distributions of returns for short- and long-term debt insurances exhibit the cubic law of returns on different time-scales, which implies the existence of a finite second moment. Sellers of short-term CDS protection bear a higher tail risk of more extreme returns than long-term CDS, especially on shorter time scales. Cross-sectionally, countries in the core region that have a lower probability of credit default imply a greater tail risk than in the peripheral region. This phenomenon can be explained by the significant impact of volatility on the tail distribution. My evidence suggests that credit default swaps of core countries with cheap insurance prices pay off in high-risk states and thus are valuable hedges against extreme events. I show that these findings have important implications for risk management, portfolio allocation, and asset pricing.