Contagion in Risk Markets

Abstract

During periods of market dislocation, which can be characterized by high asset volatility, correlations between assets generally tend to increase. However, there has been little research on the behavior of correlations between risk measures across securities markets. The aim of our research is to examine correlation dynamics between alternative risk measures rather than asset classes. Correlations between credit default swaps, equity volatility skew, and at-the-money volatility were found to increase during the recent period of market dislocation. To ascertain when the dislocation period began, we built a regime shift model to estimate the date at which the dislocation began. We have chosen to focus our analysis on risk measures for financial institutions in particular, as this industry has been most severely affected by the current financial crisis.