Sovereign CDS Market Research Articles

Global risk spillover and the predictability of sovereign CDS spread: International evidence

Using an error correction model, we document strong evidence of Granger causality in mean from the S&P option market to the sovereign CDS market in 98% of the 56 sovereigns we investigate. Tests under conditional heteroskedasticity provide further evidence of the risk spillover effect from the S&P index option market to the CDS market in mean, variance, and value-at-risk. The strong spillover effect during the recent financial crisis implies that global shocks first affect the S&P option market and then spill over to the sovereign CDS market. We demonstrate that our results are quite robust.

Analysing Sovereign Credit Default Swaps of Baltic Countries

The paper analyses development of the Baltic sovereign CDS market. The level of commonalities and differences in credit risk of the Baltic countries with regard to CDS spreads is investigated. We apply principal component analysis, regression analysis, correlation analysis methods and Granger causality test. Driving forces for changes of CDS spreads in the individual country are established. We discover that the main impact of CDS spread changes arrives from external sources. Our study reveals interdependence between CDS spreads of the Baltic countries and analyses a contagion effect of the change of CDS spreads.

The Determinants of the Sovereign CDS Volume

We analyze the sovereign CDS market for 57 countries, using a novel dataset comprising weekly positions and turnover data. We document that CDS markets - measured relative to a country's debt - are larger for smaller countries, countries with a rating just above the investment-grade cutoff, and countries with weaker creditor rights. Analyzing changes in credit risk, we find that rating changes matter but only for negative rating events (downgrades and negative outlooks). In particular, weeks with downgrades and negative outlooks are associated with a significantly higher turnover in the sovereign CDS market - even after controlling for changes in sovereign CDS spreads. We conclude that agencies' ratings are a major determinant of the size of the sovereign credit default swap market.

Economic and Financial Determinants of Credit Risk Premiums in the Sovereign CDS Market

We specify and estimate no-arbitrage models that value sovereign CDS contracts by assuming that the country's default intensity depends on observable economic and financial indicators. We estimate these models using a sample of twenty-eight countries, three CDS maturities, and over a decade of daily data. The models provide a good fit. The impact of the economic and financial variables on spreads varies substantially across countries and over time, but is consistent with economic intuition. Spreads increase as a function of stock market and exchange rate volatility, but decrease as a function of interest rates and stock market returns. Estimated risk premiums are highly time-varying and peak during the 2008 financial crisis for nearly all countries. For European countries the risk premiums are also high during the Eurozone debt crisis. In periods of market stress and high CDS spreads, the increase in market risk aversion is even larger than the increase in default probabilities. The cross-sectional variation in risk premiums across countries is high, also in non-crisis periods.

Mutual excitation in Eurozone sovereign CDS

We study self- and cross-excitation of shocks in the Eurozone sovereign CDS market. We adopt a multivariate setting with credit default intensities driven by mutually exciting jump processes, to capture the salient features observed in the data, in particular, the clustering of high default probabilities both in time (over days) and in space (across countries). The feedback between jump events and the intensity of these jumps is the key element of the model. We derive closed-form formulae for CDS prices, and estimate the model by matching theoretical prices to their empirical counterparts. We find evidence of self-excitation and asymmetric cross-excitation. Using impulse-response analysis, we assess the impact of shocks and a potential policy intervention not just on a single country under scrutiny but also, through the effect on cross-excitation risk which generates systemic sovereign risk, on other interconnected countries.

Rating Agencies' Monitoring and Certification Services - Evidence from the Sovereign CDS Market

This paper investigates the reaction of credit default swaps spreads to changes in rating class, outlook, and watchlist entries for sovereigns. We find a stronger response to negative outlook and watchlist changes than for actual rating class downgrades, which shows that negative outlook and watchlist changes reveal more information. Consistently, we are able to predict future negative outlook changes and negative watchlist entries from abnormal CDS movements. Abnormal credit default swaps spread responses are analyzed with an unrestricted market model, which allows a sound interpretation of the reaction while controlling for market movements. Additionally, we compare the reaction of high and low quality obligors to credit rating agencies' announcements with respect to timing and magnitude. We find more signicant reactions for low quality sovereigns with higher magnitudes before and at the announcement day, indicating higher sensitivity to rating changes compared to high quality obligors.

Mutual Excitation in Eurozone Sovereign CDS

We study self- and cross-excitation of shocks in the Eurozone sovereign CDS market. We adopt a multivariate setting with credit default intensities driven by mutually exciting jump processes, to capture the salient features observed in the data, in particular, the clustering of high default probabilities both in time (over days) and in space (across countries). The feedback between jump events and the intensity of these jumps is the key element of the model. We derive closed-form formulae for CDS prices, and estimate the model by matching theoretical prices to their empirical counterparts. We find evidence of self-excitation and asymmetric cross-excitation. Using impulse-response analysis, we assess the impact of shocks and a potential policy intervention not just on a single country under scrutiny but also, through the effect on cross-excitation risk which generates systemic sovereign risk, on other interconnected countries.

The Impact of Distressed Economies in the EU Sovereign Market

Financially distressed economies inside the European Union (EU) are blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within EU countries using the information content in the sovereign CDS market. We proceed in two directions: first, we test the existence of cross-border volatility effects between central and peripheral EU countries. Second, we explore the effect of distressed economies on default and risk premium constituents of sovereign default swaps. We show a significant volatility spillover from distressed to central European Economic and Monetary Union (EMU) economies. This causality pattern leads to a significant impact on default swap risk premia. On average, risk premium accounts for around 25% of central EMU spreads, doubling for those countries outside the EMU. Peripheral risk also affects the default component of central economies, although its impact is lower.

The Announcement Effect of the EFSF

This paper documents the market reaction to the introduction of the European Financial Stability Facility (EFSF) in 2010 and 2011. The effect on borrowing rates is ambiguous - Greece, Ireland, Portugal, Spain, Italy and Slovenia exhibit a decrease in rates on event days, the remaining Eurozone countries exhibit an increase. The sovereign CDS market shows that not all of the effect on rates can be attributed to the assumption of default risk. CDS spreads do not increase in the case of Germany, France, the Netherlands, and Finland, consistent with a moderate increase in riskless rates. However, the net effect on the value of all Eurozone debt is positive and amounts to EUR 108 billion. Market participants also seem to anticipate an impact on real economic conditions given that the increase in non-financial equity value is EUR 126 billion, or 1.4% of Eurozone GDP.