The European tango between market risk and credit risk: A non-linear approach

Abstract

Financial markets are closely connected, with credit and market risks dynamically influencing each other, particularly during extreme events. While their interdependence is well-documented in the literature, the direction and intensity of information flow remain uncertain. Using transfer entropy on European credit and stock volatility indices, we quantify this flow and its dynamics during the most recent extreme events. Our findings reveal a shifting dominance, with the credit market leading during extreme uncertainty, challenging the conventional view of risk market leadership. These patterns underscore the need to monitor the credit market as a potential early warning sign of financial instability.