The CDS-bond basis arbitrage in emerging markets: extreme sovereign risk

Abstract

Financial markets, that are interconnected, have become more threatening to the economic world, especially when engaging in risky transactions. After the global financial crisis of the 2008-2009, massive investment funds with very short horizons flow to emerging market economy (EME). Since 2010, investors should face the illiquidity of the sovereign debt in this market. In order to understand the behavioural diversity of investors in emerging market (EM), this article focuses on the sovereign bonds and derivatives in emerging market during the European sovereign debt crisis and it aims to give an analysis of the influence of CDS-bond basis trade on the pricing of sovereign bonds. During the European sovereign debt crises (2010-2013), we will demonstrate that the liquidity situation of the emerging market sovereign bond is worsening. Our work is based on theoretical models of Brunnermeier and Pedersen (2009) that argue when the financial sector's funding liquidity and an asset's market liquidity risks join together, a liquidity spiral can develop.