Short-term determinants of the idiosyncratic sovereign risk premium: A regime-dependent analysis for European credit default swaps

This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility.     

The anatomy of sovereign risk contagion

The channels for the cross-border propagation of sovereign risk in the international sovereign debt market are analysed. Identifying sovereign credit events as extraordinary jumps in CDS spreads, we distinguish between the immediate effects of such events and their longer term spillover effects. To analyse “fast and furious” contagion, we use daily CDS data to conduct event studies around a total of 89 identified credit events in a global country sample. To analyse “slow-burn” spillover effects, we apply a multifactor risk model, distinguishing between global and regional risk factors. We find that “fast and furious” contagion has been primarily a regional phenomenon, whilst “slow-burn” spillover effects can often be global in scope, especially those of the recent European debt crisis. The global risk factors are found to be driven by investor risk appetites and debt levels, whilst the regional factors depend on economic fundamentals of countries within a region.     

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.     

Sovereign CDS Spreads,Volatility, and Liquidity: Evidence from 2010 German Short Sale Ban

The paper examines global impact of 2010 German short sale ban on sovereign credit default swap (CDS) spreads, volatility, and liquidity across 54 countries. We find that CDS spreads continue rising after the ban in the debt crisis region, which suggests that the short selling ban is incapable of suppressing soaring borrowing costs in these countries. However, we find that the ban helps stabilize the CDS market by reducing CDS volatility. The reduction in CDS volatility is greater in the eurozone than that in the non‐eurozone. Furthermore, we find that the CDS market liquidity has been impaired during the ban for the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) countries. In contrast, there are no dramatic changes in the market liquidity for non‐PIIGS eurozone and non‐eurozone samples. The findings suggest that the short sale ban is ineffective to reduce sovereign borrowing costs in the debt crisis region if the underlying economy has not been significantly improved.     

Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, while some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.     

Conditional sovereign CDS in market basket risk scenario: A dynamic vine-copula analysis

This study examines the sensitivity of sovereign CDS markets in G7 and BRICS, which is conditional on a joint market basket risk scenario consisting of crude oil, gold, stock indices, exchange rates, freight indices, and copper prices. By compare the conditional and unconditional sovereign CDS returns using dynamic Vine-Copula model, we find that: 1) The conditional sovereign CDS returns will be less than (greater than) the unconditional ones, when scenario settings is at upper (lower) quantile level. Extreme scenario risk level settings (e.g., 1% or 99%) do not always make a significant difference between conditional and unconditional sovereign CDS. 2) Major black swan evens have significant impact on the difference between the conditional and unconditional sovereign CDS, but such an impact is short-lived especially in G7 countries. 3) Taking into account of the covariate effects, the conditional risk scenarios of sovereign CDS are heterogeneous across countries, down- and up-ward tail as well risk factors associated with the market basket.     

Time-frequency comovements between sovereign CDS and exchange rates: The role of sentiments

This study introduces various bivariate, multiple, and partial wavelet methods to explore the role of inclusive market sentiments in comovements between sovereign credit default swap (CDS) spreads and exchange rates from a time-frequency perspective. The empirical results show that the sovereign CDS spread and exchange rate nexus varies across countries and time-frequency domains. Further, the strong and positive comovements between sovereign CDS spreads and exchange rates are uncovered, concentered at medium- and long-term frequencies, especially in commodity-dependent countries. Among the various market sentiments, Volatility Index and Chicago Board Options Exchange Crude Oil Volatility are revealed as the most critical factors driving the comovements in commodity-dependent countries. The findings provide important recommendations for investors, regulatory authorities, and policymakers to understand the pivotal roles of market sentiments in inducing comovement between sovereign CDS spreads and exchange rates.     

Has the CDS market influenced the borrowing cost of European countries during the sovereign crisis?

This paper assesses the potential influence of the growing CDS market on the borrowing cost of sovereign states during the European sovereign crisis. We analyze the sovereign debt market to ascertain the pattern of information transmission between the CDS and corresponding bond markets. Our methodological innovation is the use of a non-linear specification rather than the linear VECM specification customarily employed. Using a panel smooth transition model during the 2008–2010 period, we find that: 1) linearity tests clearly reject the null hypothesis of a linear transmission mechanisms between the bond and the CDS markets; 2) market distress alters the mutual influence and 3) the higher the distress the more the CDS market dominates the information transmission between CDS and bond markets.     

The impact and the spillover effect of a sovereign rating announcement on the euro area CDS market

This paper analyzes the impact and the spillover effect of a sovereign rating announcement on the euro area CDS market. Through the event study technique, we demonstrate that downgrades and upgrades considerably affect financial markets. The relevance of the impact is due to the introduction of “new” information after a rating change announcement (information discovery effect) and to the role of rating in the current financial regulation (certification effect). Conversely, the CDS market does not seem to react significantly to rating warning (outlook and review) announcements. Furthermore, we find evidence of a spillover effect only after a downgrade announcement. Our results show that the size of the spillover effect is influenced by economic and financial conditions of analyzed countries and that international bank flows between EMU Members represent an important transmission channel of the spillover effect.     

The impact of distressed economies on the EU sovereign market

Financially distressed economies inside the European Union (EU) are being blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within the EU countries using the information content in the sovereign Credit Default Swap (CDS) market. We proceed in two directions. First, we test the existence of cross-border volatility effects between the central and the peripheral EU countries. Second, we explore the effect of distressed economies on the 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 the default swap risk premia. On average, the risk premium accounts for approximately 42% of central EMU spreads and 56% of the spreads for those countries outside of the EMU. The peripheral risk also affects the default component of central economies, although its impact is lower.     

Disentangling contagion among sovereign CDS spreads during the European debt crisis

During the last crisis, developed economies' sovereign credit default swap (hereafter CDS) premia have gained in importance as a tool for approximating credit risk. In this paper, we fit a dynamic factor model to decompose the sovereign CDS spreads of ten OECD economies into three components: a common factor, a second factor driven by European peripheral countries and an idiosyncratic component. We use this decomposition to propose a novel methodology based on the real-time estimates of the model to characterize contagion among the ten series. Our procedure allows the country that triggers contagion in each period, which can be any peripheral economy, to be disentangled. According to our findings, since the onset of the sovereign debt crisis, contagion has played a non-negligible role in the European peripheral countries, which confirms the existence of significant financial linkages between these economies.     

主权CDS对欧元区主权债务危机的影响

本文概括了主权CDS是否影响欧元区主权债务危机的几种观点和研究,发现了其中的不足之处,并试图进行弥补。文章基于面板数据,在对样本区间和国家进行分组的基础上,用向量误差修正模型(VECM)检验了主权CDS息差与国债息差的价格发现过程,此外还用向量自回归(VAR)模型分析了各国主权CDS息差之间的传染效应。结果发现,虽然主权CDS在价格发现过程中占据领先地位,但是没有证据表明主权CDS与主权债务危机之间存在必然的联系,而各国债务危机之间确实存在传染效应。     

Transmission of the financial and sovereign debt crises to the EMU: Stock prices,CDS spreads and exchange rates

This paper tests for the transmission of the 2007–2010 financial and sovereign debt crises to fifteen EMU countries. We use daily data from 2003 to 2010 on country financial and non-financial stock market indexes to analyze the stock market returns for three country groups within EMU: North, South and Small. The following results hold for both the North and South European countries, while the smallest countries seem to be relatively isolated from international events. First, we find strong evidence of crisis transmission to European non-financials from US non-financials, but not for financials. Second, in order to test how the sovereign debt crisis affects stock market developments we split the crisis in pre- and post-Lehman sub periods. Results show that financials become significantly more dependent on changes in the difference between the Greek and German CDS spreads after Lehman’s collapse, compared to the pre-Lehman sub period. However, this increase is much smaller for non-financials. Third, before the crisis euro appreciations coincide with European stock market decreases, whereas this relationship reverses during the crisis. Finally, this reversal seems to be triggered by Lehman’s collapse.     

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 debt renegotiation and credit default swaps

A credit default swap (CDS) contract provides insurance against default. This paper incorporates the contract into a sovereign default model and demonstrates that the existence of a CDS market results in lower default probability, higher debt levels, and lower financing costs for the country. Uncertainty over the insurance payout when the debt is renegotiated explains why in the data, as the output declines, the CDS spread becomes lower than the bond spread. Finally, my results show that the 2012 CDS naked ban, that decreased the levels of CDS for European countries, is a welfare reducing policy.     

The reaction of emerging market credit default swap spreads to sovereign credit rating changes

This paper examines the effect of sovereign credit rating change announcements on the CDS spreads of the event countries, and their spillover effects on other emerging economies’ CDS premiums. We find that positive events have a greater impact on CDS markets in the two-day period surrounding the event, and are more likely to spill over to other emerging countries. Alternatively, CDS markets anticipate negative events, and previous changes in CDS premiums can be used to estimate the probability of a negative credit event. The transmission mechanisms for positive events are the common creditor and competition in trade markets.     

Market response of US equities to domestic natural disasters: industry-based evidence

This study investigates US industry-based price response to domestic natural disasters over the period 1960–2015. Using an event study methodology, we estimate pre-, during and post-disaster impacts. We document a slower response in the pre-disaster period than in the post-disaster period. We further find that industries react differently to the same disaster and that reactions are not always negative. For example, meteorological disasters have a positive (negative) market impact on Gold (Banking). Moreover, we provide evidence that not every industry responds similarly to different disasters, e.g., Gold reacts positively (negatively) to meteorological (geophysical) disasters.     

Credit spread interdependencies of European states and banks during the financial crisis

We investigate the interdependence of the default risk of several Eurozone countries (France, Germany, Italy, Ireland, the Netherlands, Portugal, and Spain) and their domestic banks during the period between June 2007 and May 2010, using daily credit default swaps (CDS). Bank bailout programs changed the composition of both banks’ and sovereign balance sheets and, moreover, affected the linkage between the default risk of governments and their local banks. Our main findings suggest that in the period before bank bailouts the contagion disperses from bank credit spreads into the sovereign CDS market. After bailouts, a financial sector shock affects sovereign CDS spreads more strongly in the short run. However, the impact becomes insignificant in the long term. Furthermore, government CDS spreads become an important determinant of banks’ CDS series. The interdependence of government and bank credit risk is heterogeneous across countries, but homogeneous within the same country.     

Sovereign risk spillovers: A network approach

Understanding the global financial network for sovereign debt, particularly with a focus on interaction and spillover effects of sovereign risk, has become important for policy makers as they look to protect the stability of their economies. Using high dimensional Vector Autoregression techniques and network simulation on Sovereign Credit Default Swaps (CDS)’ data of 57 countries, we identify that the global sovereign CDS network is fully integrated as there is virtually no country without any connection to at least one specific node in the system. However, each country has a unique attribute in the network, as a risk exporter or importer and/or risk transmitter. Among developed countries, the US (unsurprisingly) holds the dominant position as a risk exporter while Germany is identified as a connecting country that transmits shocks. The most connected countries in the sovereign CDS network belong to the new European Union members. We examine possible drivers of the network relationships observed, in order to better understand the risk transmission process, and find that connections in the sovereign risk network are stronger within regional groups and countries with the same level of economic development. Central and Eastern Europe and Middle East and Africa have more interactive networks than Northern Western Europe, Asia Pacific and Latin America. We also identify that financial volatility and economic policy uncertainty increase the interactions in market-based default risk assessment.     

Does the European Financial Stability Facility Bail Out Sovereigns or Banks? An Event Study

On May 9, 2010 euro zone countries announced the creation of the European Financial Stability Facility. This paper investigates the impact of this announcement on bank share prices, bank credit default swap (CDS) spreads, and sovereign CDS spreads. The main private beneficiaries were bank creditors. Furthermore, countries with banking systems heavily exposed to southern Europe and Ireland benefited, as evidenced by lower sovereign CDS spreads. The combined gains of bank debt holders and shareholders exceed the increase in the value of their banks’ sovereign debt exposures, suggesting that banks saw their contingent claim on the financial safety net increase in value.