The impact of tradeoff between risk and return on mean reversion in sovereign CDS markets

Abstract

This paper examines whether the intertemporal tradeoffs between risk and return explain mean reversion in sovereign CDS spreads. I test how mean reversion prevents the explosiveness of CDS spreads in Europe. The relationship between risk and return has been widely studied in finance. The results show that, during the pre-crisis period, sovereign CDS spread changes were more consistent with the mean reversion hypothesis for most European countries. I also find strong evidence that the intertemporal tradeoffs between volatility and return explain in part the mean reversion in the markets for European CDS. Moreover, I show that during the crisis period, CDS spreads’ changes are consistent with the random walk hypothesis and mean aversion is more important for large holding periods.