Is tail risk priced in credit default swap premia?

Abstract

We show that the propensity of a bank to experience extreme comovements in its credit default swap premia together with the market is priced in the bank’s default swap spread during the financial crisis. We measure a bank’s CDS tail beta by estimating the upper tail dependence between its default swap spreads and a credit default swap market index. Our study shows that protection sellers receive a premium for bearing the risk of extreme upward comovements in default risk. The economic significance of this effect is large yet limited to the recent financial crisis. Banks in the upper quintile of CDS tail beta have spreads that are on average 140 basis points higher than those of banks in the lower CDS tail beta quintile.