Abstract
This study examined the tail dependency structure of sovereign credit risk and three global risk factors in BRICS countries using copulas approach, which is known for its ability to provide the “true” tail correlation based on the correct marginal distribution. The empirical results show that global market risk sentiment comoves with sovereign CDS spreads across BRICS countries under extreme market events, with Brazil having the highest co-dependency followed by China, Russia, and South Africa. Therefore, it is crucial for BRICS policymakers to consider financial sector regulations that mitigate spill-over risks such as targeted capital controls when markets are distressed, to maintain financial system stability despite unrestricted access to local financial markets by risk-averse foreign investors. Such policy can proactively manage the impact of global sentiment on the country’s credit risk profile, which ultimately affects the cost of borrowing and fiscal debt service costs. Furthermore, oil price volatility is the second biggest risk factor correlated with sovereign CDS spreads for Brazil and South Africa while exchange rate risk exhibits very small co-dependence with sovereign CDS spreads under extreme market conditions dominated by tail events. On the contrary, exchange rate risk is the second largest risk factor co-moving with China and Russia’s sovereign CDS spreads while oil price volatility exhibits the lowest co-dependence to CDS in these countries. Between oil price and currency risk, evidence of single risk factor dominance is found for Russia where exchange rate risk is largely dominant (second to global sentiment), implying that Russia can mitigate or manage spillover effects on sovereign CDS spreads by enacting targeted financial sector regulations that mitigate exchange rate risk spillovers. The optimal copula family for sovereign CDSs and exchange rate volatility is confirmed as Student-t copula across all countries, suggesting symmetry and this is consistent with expectations documented in existing literature. For the global risk sentiment, optimal copula is survival type (Joe-Clayton/Gumbel) to Tawn type copulas which are asymmetrical and considers tail observations and this variable have the strongest (and positive) association with sovereign CDS spreads of BRICS than any other global risk factor under consideration in this study. This implies that global risk sentiment co-moves with sovereign CDSs when extreme tail–end observations occur such that negative sentiment weakens CDSs while extreme market optimism improves CDS spreads for BRICS countries.
M.Com. (Financial Economics)