Three essays on financial markets

Kong, Yan (2025) Three essays on financial markets. PhD thesis, University of Glasgow.

Abstract

The objective of this thesis is to investigate three distinct aspects of financial markets: (1) Credit Default Swaps and Bank Distress, (2) Deviations from Covered Interest Rate Parity for Sovereign Bonds and (3) Deviations from Covered Interest Rate Parity and Carry Trade.

It starts with the cross-country study which indicates how credit default swaps (CDS) predict bank distress for European banks. As bankruptcies in Europe are relatively rare, the paper introduces a new dataset that divides these banks into two categories (healthy and distressed banks) to examine the relationship between credit default swaps (CDS) and bank failure, together with bank information, market discipline and macro-economic indicators. Specifically, we define a future downgrade in financial condition as bank distress and we use four sets of variables: accounting indicators, market discipline, macroeconomic information and CDS to predict a future downgrade in bank’s financial condition. First, we conduct some logistic regresssions to investigate the explanatory power of credit default swap spreads on bank distress for European banks from 2005 to 2018. We conclude that after other variables are controlled for, CDS have strong and significant predictive power on future bank downgrade. In order to provide stronger evidence for such predictive power, we do some robustness tests: (1) short-term CDS on bank distress, (2) the impact of CDS on bank distress during crisis and out of crisis, (3) the explanatory power for small and large banks respectively. The result is that only out of financial crisis, CDS cannot explain much on bank distress. Therefore, we use data from 2005 to 2013 to examine a model for predicting bank failure in European banks using simulation after crisis. The key findings of this analysis are that CDS, together with bank-level and country-level indicators, improves the estimation model performance and generates more accurate out-of-sample predictions of bank distress.

For the second study, we examine deviations from covered interest parity (CIP) for sovereign bond market and three types of frictions that may cause CIP violation for bond pairs. In frictionless market, the no-arbitrage condition holds fairly well. However, arbitrage opportunities will exist after financial crisis due debt overhang. Therefore, from 2017 to 2019, we still find small CIP violations for sovereign bond markets due to bank regulation after financial crisis. The CIP violations are proxied by Basisbond. However, during Covid-19 crisis, we find the significant emergence of CIP violations for sovereign bond markets in three emerging markets (China, South Korea and Mexico). Besides, three different categories of frictions can help to explain large violations of sovereign bonds market especially during Covid-19 crisis. We choose bond pairs denominated in dollar and euro of China, South Korea and Mexico to study the impact of these frictions on bond price violations. We conclude that funding costs and macroeconomic conditions do influence CIP arbitrage opportunities for bond markets. In addition, we do some robustness tests to explore other possible determinants of the observed large basis for sovereign bonds during the COVID-19 shock: (1) the relationship of cash flow risk associated with bond characteristic and violation of defaultable sovereign bonds prices, (2) whether stock risk can explain CIP deviations for sovereign bonds, (3) the role of foreign exchange correlation risk and (4) the interaction of liquidity and economic conditions on CIP basis for bond pairs. The conclusion of robustness checks is that cash flow risk cannot explain bond price anomalies which means that we choose good bond pairs. Besides, stock risk, FX correlation risk and interply of liquidity and economic conditions cannot explain large CIP basis for sovereign bonds. Therefore, CIP arbitrage for bond markets can be only interpreted by increased secured funding cost and economic conditions.

For the third paper, we explore the relationship between deviations from the covered interest rate parity (CIP) and carry trade. Deviations from the covered interest rate parity (CIP) condition shows arbitrage opportunities in one of the largest asset markets. CIP violations could be explained by the constrained intermediaries after financial crisis. Large CIP deviations indicate that financial intermediaries are quite constrained, thus arbitragers could gain profits. During post-crisis period, large persistent deviations for major currencies are explained by debt overhang. The first section of this paper investigates the significant explanatory power of debt overhang on violations from covered interest parity after financial crisis. Then, the effect of quarter-end debt overhang on CIP deviations is examined. We conclude that tightened balance sheet constraints at week-ends translate into larger impact of debt overhang on CIP deviations in the post financial crisis period. Besides, we do an event study to examine this relationship especially during Covid-19 crisis. The finding is that as compared to the normal time, debt overhang during the Covid-19 crisis has a higher explanatory power. The second section of this paper is to adopt forward CIP trading strategy to compute excess return as a new indicator of CIP. After examining the impact of debt overhang on CIP deviations, we use cross-currency basis proxied by CIP violations to do carry trade by adopting forward CIP trading strategy that help identify the price of currency risk to do carry trade. We conclude that positive excess return of forward CIP trading strategy is associated with large deviations. In addition, we do some additional robustness tests: (1) we use return of forward CIP trading strategy as an alternative factor of CIP deviations, (2) we adopt a new indicator as a proxy of debt overhang and (3) We also consider the predictive power of 1-week debt overhang on 1-week CIP violations. The key findings of robustness tests are that there is there is a significant relationship between CIP deviations and debt overhang with the relationship being stronger for shorter maturities.

• Item Type: Thesis (PhD)
• Qualification Level: Doctoral
• Subjects: H Social Sciences > HG Finance
• Colleges/Schools: College of Social Sciences > Adam Smith Business School > Accounting and Finance
• Supervisor's Name: Strieborny, Dr Martin
• Date of Award: 2025
• Depositing User: Theses Team
• Unique ID: glathesis:2025-85086
• Copyright: Copyright of this thesis is held by the author.
• Date Deposited: 23 Apr 2025 13:48
• Last Modified: 23 Apr 2025 13:54
• Thesis DOI: 10.5525/gla.thesis.85086
• URI: https://theses.gla.ac.uk/id/eprint/85086