Are CDS Spreads Predictable? An analysis of linear and non-linear forecasting models

by Davide Avino of University of Reading, and
Ogonna Nneji of University of Reading

November 23, 2012

Abstract: This paper investigates the forecasting performance for CDS spreads of both linear and nonlinear models by analysing the iTraxx Europe index during the financial crisis period which began in mid-2007. The statistical and economic significance of the models' forecasts are evaluated by employing various metrics and trading strategies, respectively. Although these models provide good in-sample performances, we find that the non-linear Markov switching models underperform linear models out-of-sample. In general, our results show some evidence of predictability of iTraxx index spreads. Linear models, in particular, generate positive Sharpe ratios for some of the strategies implemented, thus shedding some doubts on the efficiency of the European CDS index market.

JEL Classification: G01, G17, G20, C22, C24.

Keywords: Credit default swap spreads, iTraxx, Forecasting, Markov switching, Market efficiency, Technical trading rules.

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