Sovereign CDS Research Articles

What drives the dynamic relationship between sovereign credit default swaps and exchange rates?

What drives the dynamic relationship between sovereign credit default swaps and exchange rates?

African Sovereign Risk Premia and International Market Assets: A Relook Under The COVID-19 Outbreak

Using the wavelet multiscale coherence technique, the paper examines the interdependences between global market assets, sovereign credit default swap (CDS) and yield-to-maturity on bond spread for African economies from January 2019 to March 2023. The empirical results primarily reveal a high level of coherence between global market assets and Africa’s sovereign CDS and yield-to-maturity, although varying across countries and time-frequency domain. Notably, the high degree of coherence and the positive co-movement between sovereign CDS and global market assets are more concentrated at the medium and upper frequency bands. The observed intensity of co-movements between global market assets and sovereign CDS/yield-to-maturity (YTM) of bond spread, with global market assets broadly serving as leading variables, suggests that an increased global investor’s risk aversion positively affects the yields on Africa market bonds. Among the global market assets, we identified that VIX (which is implied volatility of S&P500) has the dominant influence on Africa sovereign CDS/YTM compared to that emanating from Bitcoin and Godman Sachs Commodity Index. This is highly conceivable as VIX gauges bubbling global risks and uncertainties which considerably influences investor’s risk aversion. The heterogeneous lead/lag dynamics also provide useful information to global investors, including by utilizing African markets to rebalance their portfolios for risk management purposes. The empirical findings thus provide further critical information to investors for hedging purposes, and to policymakers in formulating sovereign risk management policies oriented towards minimizing sovereign default risks.

Term spread spillovers to Latin America and emergence of the ‘Twin Ds’

This paper investigates the relationship between depreciation and default risks in five key Latin American markets—Brazil, Chile, Colombia, Peru, and Mexico—in response to shifts in the US yield curve slope. Excluding serial defaulters like Argentina, our focus lies on countries still susceptible to the Twin Ds phenomenon amidst high debt levels. We find that global economic spillovers significantly influence the Twin Ds in these markets; with fluctuations in the US term spread serving as an indicator of broader shifts in global economic conditions. Our analysis reveals asymmetric spillover effects, particularly during periods of positive and increasing spreads such as the Global Financial Crisis, where changes in the term spread disproportionately impact the depreciation tail in currency markets and the high-risk tail in sovereign CDS markets. Notably, such effects are absent in stock markets, which accentuate the particular dynamics of currency and sovereign debt markets. The asymmetry of spillover effects although still present during the most recent Covid-19 crisis, was less pronounced, which may be linked to the accumulation of international FX reserves in the region during the last decades. Our findings emphasize the necessity of incorporating risk spillovers into policy frameworks, highlighting the dominance of risk spillovers over price spillovers and the obscured nature of shocks at the center of the variables’ distribution.

Sovereign CDS Spread and Term Structure Forecasting Based on Neural Network

The article aims to forecast credit risk for BRICS countries using daily credit default swaps (CDS) spreads obtained from Datastream data base from 2018 to 2023. Our approach consists, first, of forecasting the CDS spread in order to estimate the forecasted CDS term structure. The general regression neural network (GRNN) is used to predict the CDS spread. By checking the accuracy of the prediction, the results show that the GRNN model can be recommended as an effective forecasting tool for CDS spread. Second, the predicted spreads are used to estimate the forecasted CDS term structure using the Nelson–Siegel model. The results show that for Russia, overall, the CDS spreads in the long term are less than those in the short term, which implies that the future outlook is more optimistic, given the events that occurred during the study period, but it still retains the highest level of credit risk compared to other countries. Unlike Brazil, India and South Africa, the future outlook is more pessimistic. For China, the term structure is unstable; in the short term, there is a tendency to reduce the risk, but for longer horizons, the risk will increase. Thus, BRICS countries have different risk profiles depending on investment horizons. The study’s findings help policymakers in developing tailored risk management strategies for BRICS countries and guide investors in making informed credit investment decisions. The use of advanced forecasting tools like GRNN and Nelson–Siegel models emphasizes the importance of sophisticated techniques in enhancing financial market resilience.

Time-varying co-movement of sovereign credit default swaps markets: Evidence from Asia-Pacific countries

This study explores the drivers of the co-movement of major sovereign credit default swaps (CDS) markets in Asia-Pacific countries. The lower differentials in fiscal performance among the sample countries contribute to an increase in the co-movement of the CDS markets. The political clearance differentials of corruption control among the sample countries turned out to have a negative relationship with the market co-movement. A higher similarity of social labor risk among the sample countries is positively associated with the co-movement of the CDS markets.

Forecasting sovereign CDS spreads with a regime‐switching combination method

AbstractWith the growing importance of the sovereign credit default swap (CDS) market, accurate forecasting of sovereign CDS spreads has gained significant attention. In view of the complex volatility in the series of sovereign CDS spreads, this study presents a novel combination forecasting framework, which introduces time‐varying weights to effectively combine diverse individual models. To identify optimal subsets of models, a mutual information approach is employed, while the regime‐switching method is utilized to integrate the selected models. The proposed method's efficacy is validated using data from 65 countries. Empirical findings underscore the superiority of the proposed approach over benchmark models in terms of both horizontal and directional prediction accuracy, particularly when the sovereign CDS data exhibits a balanced distribution between high and low volatility regimes.

Sovereign momentum currency returns

We study the relationship between cross-sectional sovereign credit risk and currency spot prices. We find that past (up to 12-month average) sovereign credit risk, measured by sovereign credit default swap (CDS) spreads, predict future currency spot returns. In particular, we document a significant cross-sectional currency portfolio spread in excess of the risk-free rate of return (up to 9.6% p.a.) between the highest and the lowest quintile sovereign CDS spreads. Overall, our results indicate that sovereign credit risk is systematically important for currency returns. Moreover, the level of sovereign credit risk has a persistent effect on currency returns which is consistent with a sovereign momentum effect.

Cross-border spillovers in G20 sovereign CDS markets: cluster analysis based on K-means machine learning algorithm and TVP–VAR models

Cross-border spillovers in G20 sovereign CDS markets: cluster analysis based on K-means machine learning algorithm and TVP–VAR models

Stability and risk contagion in the global sovereign CDS market under Russia-Ukraine conflict

As a leading indicator of sovereign debt risk, the performance of the sovereign CDS market during the Russia-Ukraine conflict deserves attention. This paper calculates the marginal net spillover index, constructs the sovereign CDS network based on the index, identifies the important countries in the network, and analyzes the network stability considering the differences in the roles of the countries in the network. By further analyzing the daily sovereign CDS network before and after the Russia-Ukraine conflict, we show the evolution pattern of the risk of the important countries in the network and the main risk contagion paths between countries. The paper shows that the Russia-Ukraine conflict significantly exacerbated the network’s overall risk level and instability. The major transmitters in the sovereign CDS network are characterized by the risk switch from receiving to transmitting, and the major receivers are characterized by the risk switch from latent to manifest. The risk contagion process is characterized by four stages: risk contagion to neighboring countries, risk exacerbation between Russia and Ukraine, further outward spillover, and weakening but persistent spillover. This study helps to provide a reference for investors to mitigate risk contagion in the sovereign CDS market.

European Financial Markets Integration and the Politics of Credit Rating Agencies: An Econometric Approach to Study Microeconomic Dynamics and Sustainability

Abstract On sovereign credit default swaps markets, contagion serves as a sobering reminder of the interconnectedness of global financial systems. Like ripples in a pond, the impact of sovereign default or downgrades can cascade across borders, highlighting the intricate web of dependencies among nations. Utilizing sovereign CDS spreads between 2006-2020 on local European markets, the study employs an event study methodology to assess the effects of rating changes on CDS spreads, focusing on negative events such as sovereign rating downgrades. The findings reveal that negative events have a greater impact on the CDS market than positive events, abnormal returns are higher during economic crises, and states with public debt exceeding the Maastricht criteria experience higher abnormal returns. These results suggest that investors are sensitive to adverse news and risk factors, see opportunities for profit during economic turmoil, and closely monitor fiscal sustainability metrics. Understanding and managing contagion risk in these markets requires not only vigilance but also cooperation and coordination among policymakers and market participants.

Global and local information efficiency: An examination of samuelson's dictum

The global version of Samuelson's Dictum is the conjecture that there is more informational inefficiency for global information than for country-specific information. Consistent with this conjecture, we find that sovereign CDS spreads can predict future sovereign bond yields of their underlying countries and this predictive power arises almost entirely from CDS spread's global—rather than country-specific—component. Noting the striking similarities between the evidence in stock and sovereign bond markets, we examine the underlying mechanism for the results in both markets in parallel and find further similarities across these two markets. In both cases, information appears to flow in one direction: from the sovereign CDS market to stock and sovereign bond markets and not the other way around. Information transmission occurs mostly during the days surrounding announcements of credit-rating or outlook changes, especially downgrades. These results are broadly consistent with a setup in which information acquisition and processing is costly.

From volatility to stability: understanding the role of macroeconomic factors in sovereign CDS spreads

From volatility to stability: understanding the role of macroeconomic factors in sovereign CDS spreads

Volatility Spillovers among Sovereign Credit Default Swaps of Emerging Economies and Their Determinants

This paper aims to investigate the volatility spillovers among selected emerging economies’ sovereign credit default swaps (SCDSs), including those of Saudi Arabia, Russia, China, Indonesia, South Africa, Brazil, Mexico, and Turkey. Using data from January 2010 to July 2023, we apply the time-domain and the frequency-domain connectedness approaches.Empirical results show that (i) Indonesia, followed by China and Mexico, are the main transmitters of sovereign credit risk volatility. (ii) Among global factors, the volatility index (VIX), economic policy uncertainty (EPU), and global political risk (GPR) positively impacted spillover on lower and higher quantiles. The results offer critical insights for international investors, policymakers, and researchers, emphasizing the importance of risk-aware investment strategies and cautious policy formulation in the context of financial crises and political events.

The asymmetric response of sovereign credit default swaps spreads to risk aversion, investor sentiment and monetary policy shocks

This paper investigates the determinants of sovereign credit default swaps spreads in the case of European countries. More specifically, it purposes to yield insight into how sovereign credit default swaps spreads respond to changes in investor sentiment, risk aversion, and monetary policy shocks during different market states. Using monthly data from May 2009 to December 2021 and running the quantile regression model, we show that risk aversion, investor sentiment and monetary policy affect the sovereign credit risk changes, and their effects vary across countries and markets states. More importantly, Risk aversion and monetary policy display the major asymmetric role in explaining CDS premia. However, limited asymmetric explanatory power is shown for investor sentiment. Furthermore, our findings demonstrate that the recent European debt crisis has significantly shaped the sensitivity of the sovereign credit risk spreads to the studied determinants. The findings of this study are helpful for investors in forecasting sovereign European credit spreads and hedging the countries default risk.

Modeling sovereign credit default swaps volatility at different tenures: An application for Latin American countries

Assessing the dynamics of risk premium measures and their relationship with macroeconomic fundamentals is essential for macroeconomic policymakers and market practitioners. This study analyzes the main determinants of sovereign credit default swaps (SCDS) in Latin America at different tenures, focusing on their volatility. Using a component generalized autoregressive conditional heteroskedasticity model, it decomposes volatility into permanent and transitory components. It finds that the permanent component of SCDS volatility in all tenures was higher and more persistent during the Global Financial Crisis than during the recent coronavirus shock.

Risk contagion and diversification among sovereign CDS, stock, foreign exchange and commodity markets: Fresh evidence from G7 and BRICS countries

This paper investigates tail risk contagion and diversification effects among sovereign credit default swap (SCDS), foreign exchange, stock, and commodity markets by constructing a tail event driven network. Network adjacency matrices indicate more significant cross-border risk contagion effects compared to cross-market contagion. Besides, the systemic risk decomposition results demonstrate that SCDS markets play a dominant role in the aggregate risk level, while the foreign exchange markets effectively reduce systemic risk. Moreover, tail event driven network quantile regression analysis shows that the impact of network factors at different risk levels exhibits a coexistence of symmetry and asymmetry, accompanied by market heterogeneity.

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.

The demand for central clearing: To clear or not to clear, that is the question!

This paper empirically analyses whether post-global financial crisis regulatory reforms have created appropriate incentives to voluntarily centrally clear over-the-counter (OTC) derivative contracts. We use confidential European trade repository data on single-name sovereign credit default swap (CDS) transactions and show that both seller and buyer manage counterparty exposures and capital costs, strategically choosing to clear when the counterparty is riskier. The clearing incentives seem particularly responsive to seller credit risk, which is in line with the notion that counterparty credit risk (CCR) is asymmetric in CDS contracts. The riskiness of the underlying reference entity also impacts the decision to clear as it affects both CCR capital charges for OTC contracts and central counterparty clearing house (CCP) margins for cleared contracts. Lastly, we find evidence that when a transaction helps netting positions with the CCP and hence lower margins, the likelihood of clearing is higher.

Re-examining the Impact of Oil Price Uncertainty on Sovereign CDS Spread of GCC Countries: Accounting for the Asymmetry and Outliers

We examine the effect of oil price uncertainty on sovereign credit risks in Gulf Cooperation Council (GCC) countries. Unlike past studies, we employ a structural vector autoregression with multivariate GARCH-in-mean (VAR-GARCH-in-mean) approach after filtering out outliers in the observed series. The findings show that uncertainty in the oil market has a positive impact on the sovereign Credit Default Swap (CDS) spreads of the GCC countries. Furthermore, we find that GCC sovereign CDS spreads react asymmetrically to positive and negative oil price shocks.

EUROPEAN FINANCIAL MARKETS CONNECTEDNESS AND MONETARY POLICY COMMUNICATION STRATEGY:SPILLOVER EFFECTS FOR CENTRAL AND EASTERN EUROPE

This study evaluates the impact of unconventional policy announcements by the European Central Bank (ECB) on the interconnectedness of sovereign credit default swaps (SCDS) markets in the European Union (EU) from 2009 to 2014. The findings suggest that ECB's unconventional policy measures reduced sovereign default risk not only in Eurozone nations but also in Central and Eastern European countries. To investigate the transmission of monetary policy effects across European countries, we employ the Diebold & Yilmaz connectedness framework along with an event-study approach. Our analysis reveals robust evidence of substantial positive spillovers from ECB monetary policy measures to all EU countries, effectively shielding the SCDS market from adverse shocks. Among various policy tools, we observe that asset purchase programs enhance overall connectedness, while mixed policy measures bolster within-cluster connectedness. Furthermore, our results highlight the efficacy of specific monetary policy instruments, indicating that asset purchase programs and quantitative easing are particularly effective in reducing sovereign risk. Keywords: communication strategy, financial markets, monetary policy, sovereign risk, Central and Eastern Europe