Pricing of Sovereign Credit Risk: Evidence from Advanced Economies During the Financial Crisis

Pricing of Sovereign Credit Risk: Evidence from Advanced Economies During the Financial Crisis. By C. Emre Alper, Lorenzo Forni and Marc Gerard

IMF Working Paper WP/12/24
January, 2012

Summary: We investigate the pricing of sovereign credit risk over the period 2008-2010 for selected advanced economies by examining two widely-used indicators: sovereign credit default swap (CDS) and relative asset swap (RAS) spreads. Cointegration analysis suggests the existence of an imperfect market arbitrage relationship between the cash (RAS) and the derivatives (CDS) markets, with price discovery taking place in the latter. Likewise, panel regressions aimed at uncovering the fundamental drivers of the two indicators show that the CDS market, although less liquid, has provided a better signal for sovereign credit risk during the period of the recent financial crisis.

IV. CONCLUDING REMARKS

This paper addressed the linkages and determinants of two widely used indicators of sovereign risk: CDS and RAS spreads. It focused on advanced economies during the recent financial crisis and the sovereign market tensions that followed. It showed strong co-movements between both series, especially for those countries that have come under significant market pressure. At the same time, arbitrage distortions have remained pervasive in the biggest economies. This suggests that the liquidity of the derivatives market is of paramount importance for CDS spreads to fully reflect sovereign credit risk. For those economies where the evidence stands in favor of a cointegration relationship, deviations from arbitrage have been long lasting, though in line with results in the literature. Also, CDS spreads were found to anticipate changes in RAS, suggesting that the derivatives market has been leading in the process of pricing sovereign credit risk. Regarding the role of fundamentals, we showed that variables related to fiscal sustainability are able to explain only a limited share of the variation of CDS spreads. Spreads seem to respond more to financial variables (such as domestic banking sector capitalization, short-term liquidity conditions, large-scale long-term bond purchases by major central banks) or purely global variables (global growth, global risk aversion, dummies for the different stages of the crisis).

These results refer to a specific group of advanced countries over a short span of time. They suggest that movements in CDS and RAS spreads need to be interpreted with caution. First, while in theory they should be strictly connected, CDS and RAS spreads do not, generally, follow the pattern suggested by the no-arbitrage condition. Moreover, they are affected by several factors, with global and financial considerations playing a dominant role, while at the same time leaving room for a large unexplained component. In general, however, CDS spreads seem to have provided better signals than RAS regarding the market assessment of sovereign risk: over the period covered by the analysis, they have led the process of price discoveries in those countries under market pressure and have been more correlated than RAS to those fundamentals that are expected to affect sovereign risk.

PDF here: http://www.imf.org/external/pubs/ft/wp/2012/wp1224.pdf