The price discovery process in credit derivative market: evidence from sovereign CDS market

Abstract

The US subprime loan crisis in 2007 has caused astonishing domestic and international financial turmoil, both directly and indirectly. Being a main factor in facilitating mortgage securitisation, credit derivative market is now under the blame of underestimating credit risk and aggregating the impact of credit risk. It is worthy of revisiting the contribution of credit derivative products to their underlying bond markets in discovering the true level of credit risk. In this paper, I use sampled credit default swap (CDS) contracts written on sovereign borrowers, to investigate the pricing relationship between sovereign CDS and bond markets. My purpose is to find whether the newly innovated derivative market can help bond market to reveal more pricing information on credit risk, or just add more noise to it. Applying vector error correction model (VECM) to a data sample ranging from 1999 to 2002, I find no statistical evidences with regard to the pricing contribution of sovereign CDS market. Instead, sovereign bond market advances in price discovery process by at least one week. Moreover, there exists a significant price gap between the two measures of credit risk: CDS rate and the yield spread of its underlying bond. This further reduces the effectiveness of using sovereign CDS in credit risk hedge.