The relationship between CDS spreads, term structures, and implied volatility

Abstract

The associations of four US volatility indices, VIX, VXOA, VXN, and VXD with measures of counterparty risk and macroeconomic conditions are studied over daily and weekly intervals. The model with weekly data displays a higher level of economic significance compared to its daily counterpart. Results showthat implied volatility rises with underlying positive and negative stock returns, suggesting a relationship between investor sentiment and market movements. Counterparty risk as measured by the TED spread leads to positive movements in the VIX making it synonymous with investor fear. The slope of the term structure is statistically significant and negatively correlated with implied volatility. This signals an increased pessimism during market downturns triggered by a rise in short term interest rates. Eurodollar and Gold futures do not reflect movements in implied volatility.