Sovereign CDS Spreads Research Articles

Assessing sovereign default risk: A bottom-up approach

This study assesses sovereign default risk of individual U.S. states utilizing information about default risk at the company level. We link integrated risk factors of the private sector to the overall sovereign risk of state governments in conjunction with additional financial variables. Using data on Moody’s KMV expected default frequencies (EDFs) on corporate default risk, we derive credit risk indicators for different industries. Building on these measures, we then develop state level credit risk indicators encompassing industry compositions to explain the behaviour of credit default swap (CDS) spreads for individual states. We find that market-based measures of private sector credit risk are strongly associated with subsequent shifts in sovereign credit risk premiums, as measured by CDS spreads. The developed credit risk indicators are highly significant in forecasting sovereign CDS spreads at weekly and monthly sampling frequencies. Overall, our findings suggest a strong predictive link between market expectations of private sector credit quality and expectations of sovereign credit quality - a connection that is not directly discernible from scoring models.

Sovereign tail risk

We provide a new measure of sovereign country risk exposure (SCRE) to global sovereign tail risk based on information incorporated in 5-year sovereign CDS spreads. Our panel regressions with quarterly data from 53 countries show that macro risks have strong explanatory power for SCRE. Results show that SCRE increases for countries with less fiscal space, higher interest rates, and financial stability concerns. Exposure sensitivity to public sector leverage is shown to increase non-linearly with public debt and to decrease with central banks’ sovereign debt programs. Our results imply that good forward-looking macro-finance fundamentals, such as high expected GDP growth and low credit-to-GDP ratios protect countries against sovereign risk especially in times of global distress.

Exploring the relationship between macroeconomic indicators and sovereign credit default swap in Pakistan

PurposeThis paper aims to empirically examine the long- and short-run relationship between macroeconomic indicators (exchange rates, interest rates, exports, imports, foreign reserves and the rate of inflation) and sovereign credit default swap (SCDS) spreads for Pakistan.Design/methodology/approachThe authors apply the autoregressive distributed lag (ARDL) model to explore the level relationship between the macroeconomic variables and SCDS spreads. The error correction model is estimated to examine the short-run effects of the underlying macroeconomic variables on SCDS spreads. Finally, the long-run estimates are obtained in the ARDL framework. The study uses monthly data covering the period January 2001-February 2015.FindingsThe results indicate that there is a significant long-run relationship between the macroeconomic indicators and SCDS spreads. The estimated long-run coefficients reveal that both the interest rate and foreign exchange reserves are significantly and negatively, whereas imports and the rate of inflation are positively related to SCDS spreads. Yet, the results suggest that the exchange rate and exports do not have any significant long-run impact on SCDS spreads. The findings regarding the short-run relationship indicate that the exchange rate, imports and the rate of inflation are positively, whereas the interest rate and exports are negatively related to SCDS spreads.Practical implicationsThe results suggest that State Bank of Pakistan should design monetary and foreign exchange rate polices to minimize unwanted variations in the exchange rate to reduce SCDS spreads. The results also suggest that it is incumbent to Pakistan Government to improve the balance of payments to reduce SCDS spreads. The findings also suggest that the inflation targeting policy can also help in reducing SCDS spreads.Originality/valueThis is the first study to examine the empirical determinants of SCDS spreads for Pakistan. Second, it estimates the short- and long-run effects in the ARDL framework. Third, it considers both internal and external empirical determinants of SCDS spreads.

Portfolio diversification in the sovereign credit swap markets

We develop models for portfolio diversification in the sovereign credit default swaps (CDS) markets and show that, despite literature findings that sovereign CDS spreads are affected by global factors, there is sufficient idiosyncratic risk to be diversified. However, we identify regime switching in the times series of CDS spreads and spread returns, and the optimal diversified strategies can be regime dependent. The developed models trade off the CVaR risk measure against expected return, consistently with the statistical properties of spreads. We consider three investment strategies suited for different CDS market participants: for investors with long positions, speculators that hold uncovered long and short positions, and hedgers with covered long and short exposures. We use the models to illustrate that diversification pays in the CDS market. The models are also tested for active portfolio management in Eurozone core and periphery, and Central, Eastern and South-Eastern Europe countries, and the optimized portfolio results outperform the broad S&P/ISDA Eurozone Developed Nation Sovereign CDS index. The paper concludes by identifying open questions in developing integrated enterprise-wide risk management models using CDS.

How Important Was Contagion Through Banks During the European Sovereign Crisis?

We use days with tail sovereign CDS spread changes of peripheral countries to identify the effects of shocks to the cost of borrowing of these countries on stock returns of banks from other countries. We find that tail sovereign GIIPS CDS changes have an asymmetric impact in that bank stocks benefit more from negative CDS spread shocks than they are hurt by positive shocks, which creates moral hazard and is best explained by a too-systemic-to-fail effect. The contagion effects are stronger for more pervasive shocks, so that idiosyncratic shocks to small countries, such as Greece, do not have an economically significant impact, but shocks involving large GIIPS countries or multiple GIIPS countries have such an impact. In our benchmark specification, holdings of peripheral country bonds by banks from other countries do not constitute a statistically or economically significant contagion channel for tail spread increases.

Transmission of financial stress in Europe: The pivotal role of Italy and Spain, but not Greece

This paper proposes a stochastic volatility model to measure sovereign financial distress. It examines how key European sovereign CDS affect each other, and particularly Germany, Spain and Italy as the core EU countries, after controlling for common and systematic risks. It is found that extreme bad news led to persistent and nearly permanent effects on stochastic volatility and, consequently, has an impact on sovereign CDS spreads. The stability of Germany is a close proxy for the resilience of the euro area as markets use Germany's sovereign CDS as a hedge for systemic risk. Although most of the CDS changes for Germany during 2009-16 were due to idiosyncratic factors, market developments in Italy and Spain contributed significantly, probably due to their relative size and importance in the region. Changes in Greece's sovereign CDS had no significant effect on core's European sovereign CDS despite initial widespread concerns about such linkages. Spain and Italy show a notable co-dependence in explaining each other's volatility, supporting their relative importance.11We would like to thank to the editor of the journal and two anonymous referees for very useful comments. We are also grateful for useful discussions and comments received from participants at seminars organized at the IMF, MIT, the 2015 World Finance Conference and the 2015 Paris Financial Management Conference.

The Zero Risk Fallacy? Banks' Sovereign Exposure and Sovereign Risk Spillovers

European banks are exposed to a substantial amount of risky sovereign debt. The “missing bank capital” resulting from the zero-risk weight exemption for European banks for European sovereign debt amplifies the co-movement between sovereign CDS spreads and facilitates cross-border financial-crisis spillovers. Risks spill over from risky periphery sovereigns to safer core countries, but not in the opposite direction nor for exposures to countries not exempted from risk-weighting. We consider the trade-off of benefits of sovereign debt (for banks and sovereigns) and spillover risk when applying risk-weights. More bank capital as well as positive risk-weighting for sovereign exposures mitigates spillovers.

REGIME SWITCHING DETERMINANTS OF SOVEREIGN CDS SPREADS: EVIDENCE FROM TURKEY

In this study, it is assessed the main determinants of sovereign CDS spreads in Turkey from January 2006 to December 2015. Before delving into the nonlinear Markov regime-switching model estimation, a conventional one-state linear model is estimated answering to what extent the sovereign credit risk is affected in between global and country-specific market variables and by credit ratings announcement changes. In broad strokes, the regime-switching analysis reveals that among domestic variables, it is the foreign exchange rate that affects the sovereign credit risk more in more volatile periods and among global variables, the indicators standing for global volatility risk premiums and international liquidity primarily influence the changes in the sovereign CDS spread in turbulent regimes whereas proxies for global risk free rate are significant more in tranquil regimes.

News and sovereign CDS markets: evidence from the Euro area

The purpose of this paper is to trace the impact of news announcements on sovereign five-year credit default swaps (CDS) spreads of four distressed countries in the euro area (Ireland, Italy, Portugal, and Spain) with daily data spanning the period May 17, 2012 to May 23, 2014. We apply an analysis based on asymmetric conditional volatility modelling methodology. The empirical analysis provides interesting evidences. The paper finds that the influence of country-specific news variable on the dynamics of the sovereign CDS spreads was confirmed. Moreover, when considering that news originated only from distressed countries, the domestic and cross-border effects of news are restricted to unfavourable news. In particular, we find that more bad news in one country leads to an increase in its own CDS spreads and those associated with other countries confirming thus the presence of a news spillover phenomenon. In contrast, we make evidence of the spillovers of good news from the non-distressed countries onto the other countries. Clearly, the sovereign CDS markets' responses indicate that the split into bad and good news has largely been done correctly.

Why Do Investors Buy Sovereign Default Insurance?

We provide a comprehensive analysis of the determinants of trading in the sovereign credit default swaps (CDS) market, using weekly data for single-name sovereign CDS from October 2008 to September 2015. We describe the anatomy of the sovereign CDS market, derive a law of motion for gross positions and their components, and identify the key factors that drive the cross-sectional and time-series properties of trading volume and net notional amounts outstanding. While a single principal component accounts for 54 percent of the variation in sovereign CDS spreads, the largest common factor explains only 7 percent of the variation in sovereign CDS net notional amounts outstanding. Moreover, unlike for CDS spreads, common global factors explain very little of the variation in sovereign CDS trading and net notional amounts outstanding, suggesting that it is driven primarily by idiosyncratic country risk. We analyze several local and regional channels that may explain the trading in sovereign CDS: (a) country-specific credit risk shocks, including changes in a country's credit rating and related outlook changes, (b) the announcement and issuance of domestic and international debt, (c) macroeconomic sentiment derived from conventional and unconventional monetary policy, macro-economic news and shocks, and (d) regulatory channels, such as changes in bank capital adequacy requirements. All our findings suggest that sovereign CDS are more likely used for hedging than for speculative purposes.

Sovereign Credit Risk Co‐Movements in the Eurozone: Simple Interdependence or Contagion?

AbstractWe investigate credit risk co‐movements and contagion in the sovereign debt markets of 17 industrialized countries during the period 2008–2012. We use dynamic conditional correlations of sovereign credit default swap spreads to detect contagion. This approach allows us to separate contagion channels from the determinants of simple interdependence. The results show that, first, sovereign credit risk co‐moves considerably, particularly among eurozone countries and during the sovereign debt crisis. Second, contagion varies across time and countries. Third, similarities in economic fundamentals, cross‐country linkages in banking and common market sentiment constitute the main channels of contagion.

The Lead - lag Relationships among Stock Index, Sovereign CDS Spread, and Volatility Index in Korean and Japanese Markets

The Lead - lag Relationships among Stock Index, Sovereign CDS Spread, and Volatility Index in Korean and Japanese Markets

Spillover dynamics for systemic risk measurement using spatial financial time series models

We extend the well-known static spatial Durbin model by introducing a time-varying spatial dependence parameter. The updating steps for this model are functions of past data and have information theoretic optimality properties. The static parameters are conveniently estimated by maximum likelihood. We establish the theoretical properties of the model and show that the maximum likelihood estimators of the static parameters are consistent and asymptotically normal. Using spatial weights based on cross-border lending data and European sovereign CDS spread data over the period 2009–2014, we find evidence of contagion in terms of high, time-varying spatial spillovers in the perceived credit riskiness of European sovereigns during the sovereign debt crisis. We find a particular downturn in spatial dependence in the second half of 2012 after the outright monetary transactions policy measures taken by the European Central Bank. Earlier non-standard monetary operations by the ECB did not induce such changes. The findings are robust to a wide range of alternative model specifications.

Oil prices and sovereign credit risk of oil producing countries: an empirical investigation

The low oil price recently has caused fears about the sustainability of public finances in some oil producing countries. We examine the relationship between oil prices and sovereign credit risk examining the CDS market. Analysing data from nine countries (Brazil, Malaysia, Norway, Qatar, Russia, Saudi Arabia, the United Kingdom, the United States of America and Venezuela) we have estimated bivariate VAR-GARCH-in-mean models. The results of our empirical investigations generally speaking do suggest that positive oil price shocks lead to lower sovereign CDS spreads. Thus, our findings support the hypothesis that higher oil prices improve the fiscal stability of oil producing countries.

Does Central Bank Quality Determine Sovereign Ratings and Credit Default Swap Spreads: Evidence from the World?

AbstractThis study innovates from prior research which focuses on the determinants of sovereign ratings and credit default swap spreads for a large sample of countries by incorporating the quality of central banks, let alone refined proxies. Findings show that the explanatory power of both sovereign ratings and CDS spreads model improve by a hefty 11 percent in case of sovereign ratings and 6 to 9 percent in the case of CDS spreads when central bank quality is incorporated. Such a finding bolters the notion that institutional quality does play a preponderant role when it comes to assessing country risk, making it a systematic component of institutional quality. The effect of labour participation implies that countries buffeted by stronger effects of an ageing population have greater propensity of increases in CDS spreads. Evidence is also found as to the driving dynamics of CDS spreads and sovereign ratings to be distinct. Our results hold robust post tackling for endogeneity problem.

The reaction of sovereign CDS spread volatilities to news announcements

This article explores the market reaction to news announcements extracted from the Eurointelligence newsflash. The data used in this work are yield spreads associated with 5-year sovereign credit default swap (hereafter, CDS) of a sample of euro area countries from May 15, 2012 until May 23, 2014. To this aim we used the exponential generalized autoregressive conditional heteroskedastic model which is an extended form of the GARCH model. Overall, our results provide considerable evidence that news is an important driver for CDS spread volatility. Specifically, we find that more news regarding the country-specific crisis raises the volatility. Moreover, the estimation results suggest that higher news in one selected country imply an increase in the CDS volatility of other countries, highlighting the presence of positive news spillover effect across euro-area countries.

Sovereign CDS spread determinants and spill-over effects during financial crisis: A panel VAR approach

This paper examines the determinants of CDS spreads and potential spillover effects for Eurozone countries during the recent financial crisis in the EU. We employ a Panel Vector Autoregressive (PVAR) model which combines the advantages of traditional VAR modelling with those of a panel-data approach. In addition to variables that proxy for global and financial market spread determinants we also employ variables that proxy for behavioral determinants. We find that the determinants of CDS variance are neither uniform nor stable during different periods and different countries. For instance, as we move from 2008 to 2014 the impact of the slope of the term structure on CDS spread variance is increasing for peripheral countries such as Spain, Portugal, Italy, Greece, Ireland, and decreasing for core countries such as Germany, France, Netherlands, Belgium and Austria. Other findings indicate that investor sentiment was an important CDS spread determinant during the subprime crisis, along with other factors, while spillover effects run from larger peripheral economies such as Spain and Italy to core countries; spillover effects from Portugal, Greece, and Ireland are of minor importance.

Portfolio Diversification in the Sovereign Credit Swap Markets

We develop models for portfolio diversification in the sovereign credit default swap (CDS) markets and show that, despite literature findings that sovereign CDS spreads are affected by global factors, there is sufficient idiosyncratic risk to be diversified away. However, we identify regime switching in the times series of CDS spreads, and the portfolio diversification strategies may differ between regimes. The models trade off the CVaR risk measure against expected return. They are tested in an active management setting for Eurozone core, periphery, and Central, Eastern and South-Eastern Europe (CESEE) countries. Models are developed for investors with long positions in CDS, speculators that hold uncovered long and short positions, and hedgers with covered long and short exposures. The results compare favorably with the broad S\&P/ISDA Eurozone Developed Nation Sovereign CDS index. We also identify several issues that remain unexplored on the way to developing integrated risk management models for CDS portfolios.

How Does Sovereign Bond Market Integration Relate to Fundamentals and CDS Spreads?

We observe significant heterogeneity across countries and maturities in the degree and dynamics of sovereign bond market integration. We analyze the role of credit quality, political and inflation risks, liquidity and investor sentiment in integrating developed and emerging bond markets and show that political risk and credit quality are the dominant factors. Bond market integration is significantly negatively related to sovereign CDS spreads. A one percent increase in integration corresponds to an average decrease in the cost of funding of about 3% of the average observed 5-year CDS spreads across all developed bond markets.

Sovereign and bank Interdependencies—Evidence from the CDS market

This paper investigates the bidirectional relationship between banking and sovereign debt crises. An extended model of Bolton and Jeanne (2011) with financial intermediaries and a government sector shows that sovereign default may induce a banking crisis as banks hold a large amount of government bonds. Nevertheless, a significant amount of outright bailouts or explicit bank guarantees may constrain the short-term liquidity of the government sector and trigger a sovereign debt crisis. Empirical analyses using the credit default swap (CDS) spreads of 11 European countries and 26 commercial banks from 2006 to 2012 support the theoretical findings. First, there was minimal comovement between bank and sovereign CDS spreads at the country level before the financial crisis. The correlation has increased significantly after the outbreak of the subprime crisis but notably dropped until the Greek debt crisis. Secondly, the same set of global risk factors could explain variations in both bank and sovereign CDS spreads after 2007 with higher sensitivity to the financial sector. Lastly, the study of price dynamics reveals that bank CDS spreads assumed the leading role prior to the Lehman Brothers bankruptcy but was gradually replaced by sovereign CDS spreads during the course of the Eurozone debt crisis. This suggests that investors have interpreted the sovereign credit risk as the main source of bank risk and traded sovereign CDS contracts to hedge financial risk. Bank guarantees and bailout programs prompted deteriorating fiscal conditions that ultimately led to a reverse spillover effect from the sovereign to the financial sector.