Sovereign Credit Default Swap Market Research Articles

Sovereign Credit Default Swap Market Volatility in BRICS Countries Before and During the COVID-19 Pandemic

SCDS (Sovereign Credit Default Swaps) are becoming more widely used as a country risk indicator after 2008 and stand out for providing real-time information rather than periodic reporting. The COVID-19 pandemic has led to economic disruptions and a decline in international trade. Understanding how the Pandemic affects SCDS return volatility in emerging economies like BRICS forms the motivation for our research. With this study, we aim to determine the impact of the COVID-19 Pandemic on SCDS return volatility in Brazil, Russia, India, China and South Africa, known as the BRICS countries. We used the Exponential Generalized Autoregressive Conditional Heteroskedasticity (EGARCH) model to analyze the data, which consisted of the daily closing price data for SCDS. The date of the first COVID-19 case in each country has been taken as the beginning of the COVID-19 Pandemic in each country. The results of the estimated GARCH models show that the volatility processes of the SCDS return series differ between periods. EGARCH model results indicate that shocks created by news in these countries during the Pandemic have a small and persistent effect on Brazil and Russia's SCDS return volatility, while they have a large and enduring effect on China and South Africa's SCDS return volatility. The findings will guide policymakers and portfolio managers in determining risk management models.

Contagion in the Euro area sovereign CDS market: a spatial approach

PurposeThis paper explores whether the Euro-area sovereign credit default swap market is prone to contagion effects. It investigates whether the sharp increase in sovereign CDS spread of a given country is due to a deterioration of the macroeconomic variables or some form of contagion.Design/methodology/approachFor this purpose, the authors use an innovative approach, i.e. spatial econometrics. Although modeling spatial dependence is an attractive challenge, its application in the field of finance remains limited.FindingsThe empirical findings show strong evidence of spatial dependence highlighting the presence of pure contagion. Furthermore, evidence of wake-up call contagion-increased sensitivity of investors to fundamentals of neighboring countries and shift contagion-increased sensitivity to common factors are well recorded.Originality/valueThis study aims to study a crucial financial issue that gained increased research interest, i.e. financial contagion. A methodological contribution is made by extending the standard spatial Durbin model (SDM) to analyze and differentiate between several forms of contagion. The results can be used to understand how shocks are spreading through countries.

Modeling the global sovereign credit network under climate change

Climate change is becoming an urgent issue for the global economy. Our study employs a multivariate extreme value regression model that incorporates a LASSO-type estimator to investigate the tail dependence of the global sovereign credit default swap market conditional on climate change. Herein, we propose an extremal connectedness measure based on tail dependence to construct a sovereign credit network. The findings show that extreme weather or climate disasters significantly impact country-specific sovereign risk with heterogeneous network structure outcomes. Specifically, extreme weather conditions have a strong impact on countries' sovereign credit and magnify their influence on the global sovereign credit network. Furthermore, we identify an asymmetric risk spillover effect in the global sovereign credit network, where the degree of risk spillover is higher under extremely hot weather conditions. Our analysis provides new insights into the role of climate change in sovereign risk.

From fears to recession? Time‐frequency risk contagion among stock and credit default swap markets during the COVID pandemic

AbstractThis study uses a high‐dimensional time‐frequency volatility spillover model to examine risk interactions across 32 global stock and credit default swap (CDS) markets during the coronavirus (COVID‐19) pandemic. Our empirical results mainly show that cross‐market risk spillovers between these two types of markets are rare over the whole crisis period. Adding CDS assets to the stock portfolio would significantly decrease the overall risk spillovers in the mixed portfolio. Then, the time‐frequency spillover and rolling window analyses confirm this finding and provide further evidence of frequency heterogeneity of risk spillovers during the pandemic. The outbreak of the COVID pandemic only sharply increases short‐term risk spillovers between the stock and sovereign CDS market but exerts insignificant impacts on the medium and long‐term cross‐market risk spillovers. Moreover, our results show that developed countries are net transmitters in the stock markets. In contrast, the emerging markets account for the most risk spillovers in sovereign CDS markets over the sample period, emphasizing the heterogenous adverse impacts of the pandemic across various countries and markets. Finally, we find that bailouts implemented by the US and EU central banks, though with heterogeneous impacts across frequencies, gradually enhance the confidence and resilience of investors in these markets.

Bank use of sovereign CDS in the Eurozone crisis: Hedging and risk incentives

Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008–2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk.

Network structures and idiosyncratic contagion in the European sovereign credit default swap market

This study combines conditional Granger causality and network analysis to examine the interconnectedness in the European sovereign credit default swap (CDS) market. We determine that the network is unstable in the short term and stable in the long term. Further, we visualize dynamic networks and confirm financial contagion in the 2012 European debt crisis. The sources of risk spillovers and the manner in which spillovers are transferred among countries are identified accordingly. Further, we conclude that interconnectedness can be a pricing factor for determining the sovereign CDS return. The results of the network analysis indicate that the European sovereign CDS market is a complex network system and can serve as a valuable reference for investors and policymakers.

The sovereign credit default swap market – is there anything to be afraid of? A comparison of selected central and western european economies

The sovereign credit default swap market – is there anything to be afraid of? A comparison of selected central and western european economies

Price discovery in euro area sovereign credit markets and the ban on naked CDS

Abstract The sovereign debt crisis in the euro area saw credit spreads on sovereign bonds and credit default swaps (CDS) surge for a number of member states. The rise in sovereign yields was accompanied by a significant increase in sovereign CDS market activity. This pattern raised concerns that destabilising speculation via outright short-selling of CDS (so-called ‘naked CDS’) was behind the increase in bond yields. In response, policy-makers introduced a ban on naked CDS trading. We investigate the effect of the ban on the price discovery process of sovereign credit risk, contrasting results for the post-ban period with those obtained prior to the ban. We use intraday data on sovereign CDS and bonds across a number of euro area countries. Our first main finding is that the CDS market dominates the bond market in terms of price discovery. That is, CDS premia in most cases adjust quicker to reflect new information than bond spreads. This result holds also when taking into account transaction costs. Our second main finding is that the ban on short-selling did not alter price discovery dynamics or reduce the efficiency of the market. Finally, we find that prior to the ban, CDS spreads were persistently higher than bond credit spreads, even after controlling for transaction costs. This points to the presence of market frictions that limit the ability of arbitrage forces to fully close pricing gaps between the two markets. However, these pricing discrepancies were in many cases largely eliminated following the introduction of the ban.

The Credit Default Swap market contagion during recent crises: international evidence

This paper analyzes Credit Default Swap spread dynamics to determine whether the sovereign Credit Default Swap market is subject to contagion effects. Analysis is performed on credit spreads data from 35 worldwide countries belonging to four different economic categories over a period from 2006 until 2014, covering the subprime crisis and the European sovereign debt crisis. A novel approach is proposed to estimate the Dynamic Conditional Correlations between CDS spreads using the AR(1)-FIEGARCH(1,d,1)-DCC model. Based on our findings, we put a slant on the financial market vulnerability, reinforced by contagion effects during the different phases of the crises. Furthermore, analysis of each country solely shows that contagion effects are sterner during the Eurozone crisis compared to the global financial crisis and that the level of exposure to crises differs across global markets and regions. Yet our approach provides evidences that crises spread to countries across the world regardless their economic status or geographical positions.

Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives

Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008-2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk.

SOVEREIGN CREDIT RISK, MACROECONOMIC DYNAMICS, AND FINANCIAL CONTAGION: EVIDENCE FROM JAPAN

We try to understand the nature of Japan's sovereign credit risk by examining the interaction between Japan's sovereign credit default swap (CDS) spreads and its financial indicators of macroeconomic fundamentals. We consider potential contagion from the global financial market and allow for reverse causality between CDS spreads and macroeconomic fundamentals. We find strong evidence of contagion from global stock markets to Japan's credit market when Lehman Brothers collapsed, whereas the European sovereign debt crisis only had temporary effects. We also show that several credit events, such as the 2011 Tohoku earthquake and rating cuts by rating agencies, significantly raised volatility in Japan's sovereign CDS market.

Predictability dynamics of emerging sovereign CDS markets

We compare the time-varying weak-form efficiency of Credit Default Swap (CDS) markets of 15 emerging countries by using permutation entropy approach. We find that CDS markets have different degrees of time-varying efficiency. Using several robustness test, we find that Thailand, China, South Korea and Malaysia have the most efficient CDS markets while South Africa, Colombia and Turkey are the least efficient. Our results show that CDS markets can be efficient even in the crisis episodes. Our findings also suggest a strong negative relation between sovereign risk and CDS market efficiency.

Relationship between Stock and the Sovereign CDS markets: A panel VAR based analysis

This study explores the relationship between the Stock and the Sovereign Credit Default Swaps (SCDS) markets by using a dataset of 36 countries. Specifically, we apply Panel-Vector Autoregressive (PVAR) model, to gauge the impact of one market's shocks to the other. Our results decipher that changes in stock market returns explain the significant portion of the SCDS market spreads' changes. Furthermore, the magnitude of this explanation is linked with the volatility of the SCDS market. These analyses indicate that the firsthand information about the country's sovereign credit risk is contained in the respective stock market, and can be used by participants/investors to predict the SCDS market spreads.

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.

Bank Use of Sovereign CDS in the Eurozone Crisis: Hedging and Risk Incentives

Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008-2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk.

Regulatory Intervention in the European Sovereign Credit Default Swap Market

The European Short Selling Regulation not only restricts the short selling of shares but (largely in response to the European sovereign debt crisis) also extends its reach into regulating the sovereign debt market. In particular, the Regulation imposes a prohibition on entering into uncovered sovereign credit default swaps (CDSs): a functionally equivalent mechanism to short selling the underlying bonds. This paper provides an overview of sovereign CDSs and their uses and places the concerns voiced about sovereign CDSs in context through an analysis of the relevant economic literature. It then discusses the Regulation’s provisions in the light of these findings. The paper suggests that there are many benefits to using sovereign CDSs and little to support the accusations that developments in the sovereign CDS markets aggravated the sovereign debt crisis. The restrictions may also reduce interest in the underlying bond markets and so may in fact harm the sovereign issuers the provisions were designed to protect.

The leverage effect puzzle: the case of European sovereign credit default swap market

One of the stylized facts about the behaviour of time series is that their volatility exhibits asymmetrical responses to good and bad news. In the case of stock markets, volatility seems to rise when the stock price decreases and fall when the stock price increases. This so-called “leverage effect” was first described by Black (Proceedings of the 1976 meeting of the business and economic statistics section, pp 177–181, 1976). The concept is not new and has already been comprehensively studied and implemented in many volatility models (GARCH and SV) in the form of an additional parameter in the volatility equation. However, there is no study or a theoretical explanation of the leverage effect in sovereign credit default swap spreads (hereinafter: sCDS). In this article, we discuss the possible behaviour of sCDS volatility and explain it by way of reference to the Prospect Theory by Kahneman and Tversky (Econometrica 47(2):263–292, 1979). We estimate a series of stochastic volatility models with the leverage effect, proposed by Yu (J Econom 127(2):165–178, 2005). In this model, the “leverage effect” is, in fact, the same as a coefficient of the correlation between the current return of an asset and its expected future volatility. We show that the effect does exist and differs across markets. As far as the safe European markets are concerned, the parameter is negative; in the case of extremely risky economies—it is positive. In markets of medium risk the effect varies depending on the relationship between the perceived risk and the value of the sCDS premium.

Determinants of the Size of the Sovereign Credit Default Swap Market

We analyze the sovereign credit default swap (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 CDS market.

Hawkes-diffusion process and the conditional probability of defaults in the Eurozone

This study examines market information embedded in the European sovereign CDS (credit default swap) market by analyzing the sovereign CDSs of 13 Eurozone countries from January 1, 2008, to February 29, 2012, which includes the recent Eurozone debt crisis period. We design the conditional probability of defaults for the CDS prices based on the Hawkes-diffusion process and obtain the theoretical prices of CDS indexes. To estimate the model parameters, we calibrate the model prices to empirical prices obtained from individual sovereign CDS term structure data. The estimated parameters clearly explain both cross-sectional and time-series data. Our empirical results show that the probability of a huge loss event sharply increased during the Eurozone debt crisis, indicating a contagion effect. Even countries with strong and stable economies, such as Germany and France, suffered from the contagion effect. We also find that the probability of small events is sensitive to the state of the economy, spiking several times due to the global financial crisis and the Greek government debt crisis.

Regulation of uncovered sovereign credit default swaps – evidence from the European Union

Purpose – This study aims to analyze the impact and effectiveness of the regulation on the European sovereign Credit Default Swap (CDS) market. The European sovereign debt crisis has drawn considerable attention to the CDS market. CDS have the ability of a speculative instrument to bet against a sovereign default. Therefore, the Regulation (EU) No. 236/2012 was introduced as the worldwide first uncovered CDS regulation. It prohibits buying uncovered sovereign CDS contracts in the European Union (EU). Design/methodology/approach – First, this paper measures spread changes of sovereign CDS of the EU member states around regulation specific event dates to detect whether and when European sovereign CDS reacts to regulation announcements and the enforcement of regulation. Second, it compares the CDS long-term stability of the EU sample with a non-EU sample based on 44 non-EU sovereign CDS entities. Findings – The results indicate widening CDS spreads prior to the regulation, and stable CDS spreads following the introduction of the regulation. In particular, sovereign CDS of European crisis-hit entities are stable since the regulation was introduced. Originality/value – The results show that since the regulation of uncovered CDS in the EU has been enacted, the sovereign CDS market is stable and less volatile. Based on the theory about speculation on uncovered sovereign CDS by betting on the reference entity’s default, the introduction of Regulation (EU) No. 236/2012 appears to be an appropriate measure to stabilize markets and reduce speculation on sovereign defaults.