Spillover effects and the role of systematic risk: An empirical study of interbank markets in Denmark, Euro area and the US during the Financial Crisis

Fredrik A. R. Slettvold & Espen L. Fjermestad

Student thesis: Master thesis

Abstract

Any strains or irregularities in the interbank market can have severe consequences for the general economy. Assessing how periods of financial turmoil affect the interbank market is therefore important for both policy makers and market participants. Academic research on risk premiums contained in unsecured interbank rates sparked during in the recent financial crisis. In the early months of 2008 the nationalization of Northern Rock and the subsequent collapse of Lehman Brothers sent shockwaves through the interbank market. The result was escalating risk premiums reaching levels never seen before. This thesis shows the devastating effects the recent financial crisis had on the Danish interbank market. Although Danish banks had limited exposure to subprime mortgages and Collateralized Debt Obligations (CDOs), the Danish market was largely affected by the development abroad. Utilizing various econometric techniques, this thesis demonstrates how movements in the US and the Euro area dictated minor market participants such as Denmark during the crisis. Moreover, the transmission of market tensions from foreign markets to the Danish market created what economic theory defines as spillover effects. We show how to measure and quantify spillover effects, and moreover, why it is used as an indicator of systematic risk. This relationship is interesting as the long prevailing portfolio theory states that risk is reduced through diversification. However, we identify a transition from low to high correlation between interbank markets during the crisis. Highly correlated financial markets undermine the benefits associated with portfolio diversification. Finally, this thesis shows how severely mispriced foreign exchange (FX) swaps induced higher liquidity risk in the Danish market. Due to the breakdown of the interbank market, Danish financial institutions were forced to obtain crucial USD and Euro funding through the FX swap market. As the swap market turned one-sided with few sellers and many potential buyers, the costs of accessing USD and Euro increased, effectively generating liquidity risk in the Danish market.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2010
Number of pages130