Regime-Switching Determinants for Spreads of Emerging Markets Sovereign Credit Default Swaps

Jason Ma,Kung-Cheng Ho,Xiang Deng,Sang-Bing Tsai

doi:10.3390/su10082730

Abstract

Using the Markov regime switching approach, we investigate the dependency of short term sovereign credit default swap (SCDS) spread changes on a nation’s country-specific fundamental factors, local, regional and macroeconomic global factors. We find that the significance of the determinants of SCDS spread changes differ across the two states of our regime-switching model. Specifically, in the good state, the weekly SCDS spread changes are mainly determined by local, regional and fundamental factors; whereas global variables have a stronger influence in the bad regime. In particular, US market returns play a dominant role in influencing the SCDS spread change in the bad state suggesting loss aversion and flight–to–quality behavior of investors. We then examine the cross-sectional differences of the above regime switching effect based on country-specific characters and find that the regime switching effect is associated with a nation’s country-specific characters such as openness, economic size and so forth.

Highlights

The sovereign default of Greece and the ongoing credit crisis in the Euro Zone have raised people’s concern on sovereign credit risk
Sovereign credit risk is determined by the country’s ability and willingness to re-pay its debt owing to creditors and is reflected in the spread paid for protection offered by the corresponding Sovereign Credit Default Swap (SCDS)
The results show that the impact of US stock market return on China’s sovereign credit default swap (SCDS) spread change magnifies to ~seven folds in the bad state than in the good state

Summary

Introduction

The sovereign default of Greece and the ongoing credit crisis in the Euro Zone have raised people’s concern on sovereign credit risk. SCDS spread is considered to be a timelier measure of sovereign credit risk than government bond yield spread. Ammer and Cai [2] examine the relationship between SCDS spreads and bond yields for nine emerging market sovereigns and find that these two measures of credit risk deviate significantly in the short run with the former leading the later in price discovery [3]. They attribute such deviation to the higher liquidity in trading of SCDS

Objectives

Methods

Findings

Conclusion