Extreme Risks During the U.S. Financial Crisis: An Empirical Study of the Credit Default Swap Market

This article focuses on the many extreme credit default swap spread movements observed during the recent U.S. credit crisis. The tails of the spread (and price) change distribution differ significantly from those of the normal distribution even for diversified credit derivatives portfolios. Particular focus is placed on the sudden shift in the behavior of the credit default swap market in the summer of 2007. During the first month of the crisis, July 2007, the extreme turbulence in the credit derivatives market is comparable only to the turmoil in the equity market in October 1987 and in October 2008. As a result of this extreme behavior and the dramatic regime shift observed at the start of the crisis, the credit derivatives portfolio Value at Risk estimates based on extreme value theory are more accurate than those based on the normal-, the Student's t-, or the historical distribution. Similar results appear during the crisis and in the comparably tranquil years leading up to the crisis. The results are qualitatively the same for investment-grade and high-yield credits.