Trivariate-GARCH Modeling of CDS Volatility Transmission in the Foreign Exchange Market of Korea

This paper empirically investigated the shock and volatility transmission of counterparty risk on the deviations from covered interest parity (CIP) in the foreign exchange (FX) forward market of Korea. During the recent financial turmoil, there were significant shock and volatility transmission from the counterparty risk of the European credit default swap (CDS) market to the CIP deviations of FX market under investigation. In addition, the shock of counterparty risk for US corporations was transmitted more to the Korean FX market than that of Korean sovereign risk. FX forward deviations tended to depend more on investment-grade European and US corporations than on Korean sovereign ones, because the shock and volatility of the European and US CDS indexes were transmitted more to CIP deviations than those of Korean sovereign ones. This finding is consistent with the view that the demand for dollar liquidity in the Korean FX market during the turmoil stemmed from mainly dollar London interbank offered rate (libor) panel banks, such as European and US banks, than the financial institutions of emerging countries like Korea.