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FinanceandEconomicsDiscussionSeries FederalReserveBoard,Washington,D.C.ISSN1936-2854(Print) ISSN2767-3898(Online) DefaultClusteringRiskPremiumanditsCross-MarketAssetPricingImplications KiwoongByun,BaehoKim,andDongHwanOh2023-055 Pleasecitethispaperas: Byun,Kiwoong,BaehoKim,andDongHwanOh(2023).“DefaultClusteringRiskPre-miumanditsCross-MarketAssetPricingImplications,”FinanceandEconomicsDiscus-sionSeries2023-055.Washington:BoardofGovernorsoftheFederalReserveSystem,https://doi.org/10.17016/FEDS.2023.055. NOTE:StaffworkingpapersintheFinanceandEconomicsDiscussionSeries(FEDS)arepreliminarymaterialscirculatedtostimulatediscussionandcriticalcomment.TheanalysisandconclusionssetfortharethoseoftheauthorsanddonotindicateconcurrencebyothermembersoftheresearchstaffortheBoardofGovernors.ReferencesinpublicationstotheFinanceandEconomicsDiscussionSeries(otherthanacknowledgement)shouldbeclearedwiththeauthor(s)toprotectthetentativecharacterofthesepapers. DefaultClusteringRiskPremiumanditsCross-MarketAssetPricingImplications∗ KiwoongByun†,BaehoKim‡andDongHwanOh§August11,2023 Abstract Thisstudyexaminesthemarket-impliedpremiumsforbearingdefaultclusteringriskbyanalyzingcreditderivativescontractsontheCDXNorthAmericanInvestmentGrade(CDX.NA.IG)portfoliobetweenSeptember2005andMarch2021.Ourapproachinvolvesconstructingatimeseriesofreferencetrancheratesexclusivelyderivedbysingle-nameCDSspreads.Thedefaultclusteringriskpremium(DCRP)iscapturedbycomparingtheoriginalandreferencetranchespreads,withtheformerexceedingthelatterwheninvestorsrequiregreatercompensationforcorrelateddefaultsattheportfoliolevel.ThefittedDCRPlevelsignificantlyincreasedinresponsetothe2007-9globalfinancialcrisisandremainedrelativelystableforaperiod,followedbyagradualdeclinebeginningin2016.Notably,theCOVID-19shockcausedanothersharpriseintheDCRPlevel.OurempiricalanalysisfindsthattheestimatedDCRPhassignificantimplicationsforassetpricing,particularlyinaffectingtheinvestmentopportunitiesavailabletoU.S.stockinvestorsduringtimesofinstabilityinthefinancialsystem. Keywords:CreditDefaultSwap(CDS);CDSIndex(CDX);ReferenceTrancheRate;DefaultClusteringRiskPremium ∗WethankJihyeokJeong,HeebumLee,BumjeanSohn,MarkoHansWeber,seminarpar-ticipantsatKoreaUniversityBusinessSchool,andconferenceparticipantsatAsianFA2023AnnualConferenceforhelpfuldiscussionsandcomments.ThisworkwassupportedbytheMin-istryofEducationoftheRepublicofKoreaandtheNationalResearchFoundationofKorea(NRF-2021S1A5A2A01063707). †KoreaUniversityBusinessSchool,Seoul,SouthKorea,Email:bkw1120@korea.ac.kr. ‡CorrespondingAuthor,KoreaUniversityBusinessSchool,Seoul,02841,SouthKorea,Phone:+82-2-3290-2626,Fax:+82-2-922-7220,Email:baehokim@korea.ac.kr. §FederalReserveBoard,Washington,D.C.20551,USA,Email:donghwan.oh@frb.gov. 1Introduction Creditderivativemarketparticipantsfacetheriskofencounteringcorrelateddefaults.Giventhepotentialimpactofasignificantclusterofcorrelateddefaultsontheentiresystem,marketparticipantsgenerallyrequiresignificantpremiumstoaccountforthedynamicriskofdefaulttimecorrelation.Thecreditmarket’soverallperceptionofjointlossdistributionforthereferenceentitiesintheindexcanbededucedbyexaminingthequotesofsingle-nameCreditDefaultSwap(CDS)andmulti-nameCDSindex(CDX)tranchespreads. Inthispaper,weinvestigatethedefaultclusteringriskpremium(DCRP),whichreflectstheextracompensationthatinvestorsdemandforholdingassetsexposedtotheriskofacascadeofdefaultsacrossmultipleinvestments,leadingtosystemiclossesthataremoreseverethanexpectedbasedonindividualcreditriskalone.DCRPisaformofthecreditriskpremiumthatdependsonthejointbehavioroftheunderlyingassetsandhighlightstheinter-dependenciesamongthem.Inessence,DCRPaddressestheriskpremiumforaborrower’sdefaultstriggeringotherborrowers’defaults,particularlyifthesedefaultsarecorrelatedduetocommonexposuresorcontagioneffects. DCRP’simplicationhasconsiderableacademicsignificanceinfinance.Itisalsoper-tinentforpolicymakerswhoutilizecreditmarketsignalstomakedecisions,asthesystemiccreditriskpremiumisacriticalaspectofDCRP.Consequently,itsimportanceishighlightedbyeventssuchastheglobalfinancialcrisisandtheCOVID-19pandemic,whichillustratehowmarketparticipantsperceivesystemicriskandhowfinancialsec-torissuescanimpacttherealsector.The2007-9globalfinancialcrisisdemonstratedthatriskmanagementattheindividualfinancialfirmlevelisinsufficientandunder-scoredtheneedformacroprudentialsupervisiontoensuretheholisticmanagementofsystemicrisk.TherecentCOVID-19pandemiccausedadownturninfinancialmarketsandasubsequentbankingsystemcrunchduetoincreasinginterestrates.Thishigh-lightsthepossibilityoffuturesimilarscenarios,evenwiththepotentialresolutionofthepandemic-relatedadversefeedbackloop. Thisresearchaimstoextractthetime-seriesdynamicsofDCRPbasedontheportfoliodefaultriskpremiumaftercontrollingfortheindividualdefaultriskpremium.Throughthisanalysis,potentialapproachesfordistinguishingtheportfoliodefaultriskpremiumintotwodistinctcomponents,namelytheindividualdefaultriskpremiumandthede-faultclusteringriskpremium,canbeidentified.Theformercom