Abstract
This study provides a dynamic analysis of the lead-lag relationship between sovereign Credit Default Swap (CDS) and bond spreads of the highly indebted southern European countries, considering an extensive time sample from the period before the global financial crisis to the latest developments of the sovereign indebtedness in the euro area. We employ an integrated price discovery methodology on a rolling sample, with the intention to shed light on whether the CDS spreads can trigger rises in bond spreads, and the relative efficiency of credit risk pricing in the CDS and bond markets. In addition, we attempt to depict the evolution of the price discovery process regarding the direction of influence from one market to the other. The rolling window analysis verifies that the price discovery process evolves over time, presenting frequent alternations concerning the leading market. We find that during periods of economic turbulence the CDS market leads the bond market in price discovery, incorporating the new information about sovereign credit risk faster and more efficiently than the bond market does. This regularity should be seriously considered by private and public participants as they make investment and funding decisions. Therefore, the motivation of our paper is to identify the dominant market in terms of price discovery during a period of economic turmoil and, thus, to provide insights for decision making to investment bodies and central governments.
Highlights
Credit default swaps (CDS) are over-the-counter derivative instruments that provide market participants with an alternative and unfunded channel of credit risk trade
We examine the lead-lag relationship between Credit Default Swap (CDS) and bond spreads in a time-varying context, focusing on the peripheral European countries that were in the epicenter of the sovereign debt crisis
Concerning the over-indebted southern Eurozone countries, after examining the stationarity of bond and CDS spreads’ series and, the existence of a long-run equilibrium relationship between them, the Vector Error Correction Model (VECM) and the Granger causality test suggest the following: Greece demonstrates the highest percentage of CDS spread leadership (53% of the windows), while the lowest percentage is observed in the case of Italy (15% of the windows)
Summary
Credit default swaps (CDS) are over-the-counter derivative instruments that provide market participants with an alternative and unfunded channel of credit risk trade. CDS spreads and the underlying bond spreads must be almost equal (Duffie, 1999; Hull & White, 2000; Hull, Predescu, & White, 2004; Cossin & Lu, 2005; Coudert & Gex, 2013) considering that they reflect similar information regarding the creditworthiness of a given corporate or sovereign reference entity This condition never holds in practice since the two contracts do not match perfectly (Longstaff, Mithal, & Neis, 2003; Blanco, Brennan, & Marsh, 2005; Coudert & Gex, 2010, 2013). The issue of which spread influences the other, i.e. which spread leads the pricing process, constitutes a favorable research area since it has an effect on the behavior of investors, policy makers and regulators
Sign-in/Register to view highlights & summary Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
