The emerging market sovereign debt crisis in the nineties, and particularly the recent sovereign debt crisis in Europe, have revived interest in sovereign credit risk. Sovereign debt was generally considered to be a low risk asset class. In a panoramic and historical overview of sovereign debt crises, Reinhart and Rogoff (2008) vividly illustrate the public misperception of government debt as a safe haven. The real economic consequences of sovereign default, such as inflation, exchange rate crashes, banking crises, and currency debasements, and the accompanied social costs over and above financial losses, justify the need to understand the drivers of sovereign risk. Yet, the academic literature fails to agree on the determinants of sovereign default risk, as reflected in sovereign credit spreads. A particular discussion pertains as to whether sovereign credit risk is priced globally or locally.
This paper seeks to identify the common factor(s) driving sovereign credit risk and studies the common variation in global sovereign Credit Default Swap (CDS) spreads and the strong co-movement (commonality) of the default swap term structure. The strong commonality in sovereign CDS has been emphasized in recent research by Pan and Singleton (2008) and Longstaff et al. (2010), and is illustrated in Figure 1. Motivated by their results and preliminary findings of strong negative correlation between American consumption growth and the evolution of credit indices, we attempt to explain variation in the global sovereign CDS spreads through macroeconomic fundamentals in the United States.
Structural models of credit risk following the contingent claims analysis pioneered by Merton (1974), predict a theoretical relationship between credit spreads and leverage, volatility and interest rates. Yet, their guidance in identifying the determinants of sovereign credit risk fails to be satisfactory. Reduced-form models on the other hand, while proving useful in practical applications, remain silent about the theoretical determinants of credit spreads. For sovereign spreads, the challenge to explain credit risk on the basis of theoretical intuition seems even more difficult, as default is not determined by the leverage ratio, but rather by the willingness of the government to repay its debt.
Thus, the sovereign borrower’s repayment depends on the lender’s ability to punish in case of default and the future access to international capital markets (Edwards (1984)). We refer to this inability of theoretical models to reconcile historical and model implied credit spreads and default probabilities as the sovereign credit spread puzzle, which, we argue, remains heretoforth unexplained.
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Common Factors and Commonality in Sovereign CDS Spreads: A consumption-based explanation
