Relation of CDS premiums with stock market indices: A study on fragile 5 and G7 countries

Along with the development of international finance markets, financial boundaries started to diminish and global capital's entrance to the countries, as well as their exits, gained momentum. Thus, the need to gain perpetual and instant information on the risks that a country displays before the investors invest their capitals into a country has emerged. Accordingly, Credit Default Swap contracts, which are employed as an insurance in case the dues of the investors are not paid back, have been developed. These contract premiums are called CDS spreads. All affirmative and negative information about a country's financial situation is reflected on CDS spreads instantly. Provided that there is some affirmative information about a country, CDS spreads decrease, but in case of negative information, CDS spreads increase. According to investors, the countries whose CDS spreads are high are considered as risky countries, the ones of which CDS spreads are low are considered as low risk or riskless countries. The increase or decrease occurring in CDS spreads directly affects the costs of the capital which those countries need. In the first chapter of our study, the definitions of risk, credit risk and credit derivatives and their types are discussed in detail. In the second chapter, some detailed information about country risk and Credit Default Swaps are displayed. In the third chapter of the study, firstly, there is a detailed literature review consisting of the studies which are based on the relationship between CDS spreads and stock market indexes. Afterwards, the tests and models which were utilized in our study were explained briefly, and the relationship between the CDS premium spreads of Fragile 5 and G7 countries and their stock market closing prices. In order to reach these results, firstly Augmented Dickey-Fuller (ADF) and Phillips- Perron (PP) unit root tests were utilized. In order to display the relationship among the countries, Granger Causality, Johansen Cointegration, Vector Error Correction Model and Pearson Correlation analyses were carried out. It is clear as a result of the analyses carried out that, from the group of Fragile 5, the CDS spreads and stock market indexes of India and Turkey; from the group of G7, the CDS spreads and stock market indexes of Germany, Japan and Canada displayed a short-term relationship. In long term, it was found out that, from the group of Fragile 5, merely Turkey's CDS spreads and stock market indexes displayed a relationship; while from the group of G7, Japan's and France's CDS spreads and stock market indexes displayed a relationship.