Asymmetric and nonlinear dynamics in sovereign credit risk markets

Abstract

We employ asymmetric and nonlinear error correction models to characterize the price discovery and volatility interactions between the sovereign CDS and bond spreads for 22 reference entities. We find asymmetric, nonlinear, and bidirectional short and long‐run information flow in the first and second moments. The flow from the CDS to the bond market is stronger than in the reverse direction, demonstrating that CDS market is the more effective vehicle for price discovery. The persistence of volatility implies that informed trading occurs in the CDS markets. Both markets seem to converge to an equilibrium relationship when the basis is large.