Ebook The Dynamics of Sovereign Credit Default Swap and Bond Markets: Empirical Evidence from the 2001-2007 Period
Credit Default Swap (CDS) markets give bond holders the opportunity to hedge their risks. An investor who owns a sovereign bond can eliminate his risk by buying the corresponding CDS. A hedge fund manager can make arbitrage profits if buying the bond and the CDS of the same sovereign gives a higher rate of return compared to her cost of borrowing. Similarly, a speculator who predicts that a sovereign will be in distress in the future can bet on the increase on CDS prices. Furthermore, an issuing entity such as a bank can take advantage of the asymmetric information in sovereign credit markets and make mark-up profits from the insurance business (Singh and Andritzky, 2005). Recently, it has also become a common practice for rating agencies to adopt various marked-to-market risk indicators, such as CDS Implied Ratings, highlighting the importance of CDS markets.
Sovereign bonds are the securities issued by sovereign governments. Sovereign CDSs, however, are insurance policies provided by a third financial party, such as a bank or a hedge fund, against the risk of default by a sovereign. The protection seller has to deliver the reference bond at its par value when a credit event occurs. In return, the protection buyer makes periodic payments to the seller until the maturity date of the CDS contract or until a credit event occurs. The periodic payment, which is usually expressed as a percentage (in basis points) of the principal, is called the CDS premium (Zhu, 2006). The CDS market also serves as a financial tool for investors and traders to short the sovereign bonds without any liquidity problem (Blanco et al, 2005). The major players in sovereign CDS markets are, in order of importance, banks, insurance companies, security houses, and hedge funds (Chan-Lau and Kim, 2004).
A sovereign bond spread is a premium paid by an issuing government to compensate for additional risk. This premium is generally calculated as the difference between the yield of the risky sovereign bond and the yield of a risk-free bond, such as a US or German government bond, or a risk-free market rate such as the London Interbank Offered Rate (LIBOR). Unlike bond spreads, CDS premiums (or spreads) do not incorporate any risk-free benchmarks into their calculations. However, this premium is determined by the issuing entity with a careful eye on sovereign bond markets, therefore there is a very close relationship between sovereign bond spreads and sovereign CDS premiums. In efficient markets (such as the US corporate bond markets), arbitrage forces CDS spreads to be approximately equal to the underlying bond spreads in the absence of market friction, therefore driving the basis, the difference between the CDS and the corresponding bond spread, to zero in the long-run (Hull and White, 2000; Zhu, 2006).
Starting in the mid 1990s, international bond markets gained more importance. During this time period, international financial crises and subsequent restructurings led to better functioning markets for sovereign debt. In terms of sovereign CDS markets, however, it is hard to come to any conclusions since these markets are in their infancy. Therefore, the interaction between sovereign CDS and bond markets stands as a promising research area. Uncovering the recent developments or inconsistencies in the sovereign credit markets will help governments, investors, and various regulators improve the transparency of these markets.
In modern finance literature, there are numerous studies focusing on the relationship between bond and CDS spreads. One group of studies emphasizes the relationship between bond spreads, CDS spreads, stock prices or stock market indices, and the ratings assigned by major agencies such as S&P, Moody’s, and Fitch. Most of these studies focus on the corporate bond markets as opposed to sovereigns, since the data availability for the latter is very limited. Another group focuses on the local (macroeconomic) and global factors affecting the spreads. Specifically, this group tries to explain the sovereign CDS and bond spreads with more frequent data such as daily equity indices, daily volatility measures, exchange rates, and interest rates.
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