The interactions and trade-offs of sovereign Credit Default SWAP (CDS) and bond spreads in a dynamic context
Abstract
This study provides a dynamic analysis of the lead-lag relationship between sovereign Credit Default Swap (CDS) and bond spreads of the highly indebted southern European countries, considering an extensive time sample from the period before the global financial crisis to the latest developments of the sovereign indebtedness in the euro area. We employ an integrated price discovery methodology on a rolling sample, with the intention to shed light on whether the CDS spreads can trigger rises in bond spreads, and the relative efficiency of credit risk pricing in the CDS and bond markets. In addition, we attempt to depict the evolution of the price discovery process regarding the direction of influence from one market to the other. The rolling window analysis verifies that the price discovery process evolves over time, presenting frequent alternations concerning the leading market. We find that during periods of economic turbulence the CDS market leads the bond market in price discovery, incorporating the new information about sovereign credit risk faster and more efficiently than the bond market does. This regularity should be seriously considered by private and public participants as they make investment and funding decisions. Therefore, the motivation of our paper is to identify the dominant market in terms of price discovery during a period of economic turmoil and, thus, to provide insights for decision making to investment bodies and central governments.
Keyword : credit risk, CDS, sovereign bonds, debt crisis, cointegration, Granger causality, price discovery, rolling window analysis
How to Cite
Tampakoudis, I. A., Tamošiūnas, A., Subeniotis, D. N., & Kroustalis, I. G. (2019). The interactions and trade-offs of sovereign Credit Default SWAP (CDS) and bond spreads in a dynamic context. Journal of Business Economics and Management, 20(3), 466-488. https://doi.org/10.3846/jbem.2019.9759
This work is licensed under a Creative Commons Attribution 4.0 International License.
References
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Ammer, J., & Cai, F. (2011). Sovereign CDS and bond pricing dynamics in emerging markets: Does the cheapest-to-deliver option matter?. Journal of International Financial Markets, Institutions and Money, 21(3), 369-387. https://doi.org/10.1016/j.intfin.2011.01.001
Andraz, J., Viegas, C. M., & Norte, N. M. (2015, 6-9 October). New insights on the long-term relationship between sovereign bonds debt and credit default swaps in Portugal. In IISES 2015: Proceedings of the International Academic Conference, International Institute of Social and Economic Sciences. Madrid, Spain.
Arce, O., Mayordomo, S., & Peña, J. I. (2013). Credit-risk valuation in the sovereign CDS and bonds markets: Evidence from the euro area crisis. Journal of International Money and Finance, 35, 124-145. https://doi.org/10.1016/j.jimonfin.2013.01.006
Baba, N., & Inada, M. (2007). Price discovery of credit spreads for Japanese mega-banks: Subordinated bond and CDS. IMES Discussion Paper, No. 2007-E-6.
Beber, A., Brandt, M. W., & Kavavejc, K. A. (2009). Flight-to-quality or flight-to-liquidity? Evidence from the Euro-Area bond market. Review of Financial Studies, 22(3), 925-957. https://doi.org/10.1093/rfs/hhm088
Blanco, R., Brennan, S., & Marsh, I. W. (2005). An empirical analysis of the dynamic relation between investment – grade bonds and credit default swaps. The Journal of Finance, 60(5), 2255-2281. https://doi.org/10.1111/j.1540-6261.2005.00798.x
Bowe, M., Klimaviciene, A. & Taylor, A. P. (2009, 4-7 March). Information transmission and price discovery in emerging sovereign credit risk markets. Paper presented at the Mid-West Finance Association Annual Conference, Chicago, USA.
Chan-Lau, J. A., & Kim, Y. S. (2004). Equity prices, credit default swaps, and bond spreads in emerging markets. IMF Working Paper, No. 04/27. https://doi.org/10.5089/9781451844559.001
Cossin, D., & Lu, H. (2005). Are European corporate bonds and default swap markets segmented?. Working Paper 153, FAME. https://doi.org/10.2139/ssrn.680464
Coudert, V., & Gex, M. (2013). The interactions between the credit default swap and the bond markets in financial turmoil. Review of International Economics, 21(3), 492-505. https://doi.org/10.1111/roie.12050
Coudert, V., & Gex, M. (2010). Credit default swap and bond markets: which leads the other. Banque de France-Financial Stability Review, 14, 161-167.
Delatte, A. L., Gex, M., & López-Villavicencio, A. (2012). Has the CDS market influenced the borrowing cost of European countries during the sovereign crisis?. Journal of International Money and Finance, 31(3), 481-497. https://doi.org/10.1016/j.jimonfin.2011.10.008
Delis, M. D., & Mylonidis, N. (2011). The chicken or the egg? A note on the dynamic interrelation between government bond spreads and credit default swaps. Finance Research Letters, 8(3), 163-170. https://doi.org/10.1016/j.frl.2010.09.005
Dickey, D. A., & Fuller, W. A. (1979). Distribution of the estimators for autoregressive time series with a unit root. Journal of the American statistical association, 74(366), 427-431. https://doi.org/10.2307/2286348
Duffie, D. (1999). Credit swap valuation. Financial Analysts Journal, 55(1), 73-87. https://doi.org/10.2469/faj.v55.n1.2243
European Central Bank. (2004). The Euro bond market study. ECB, Frankfurt.
Fontana, A., & Scheicher, M. (2016). An analysis of euro area sovereign CDS and their relation with government bonds. Journal of Banking & Finance, 62, 126-140. https://doi.org/10.1016/j.jbankfin.2015.10.010
Forte, S., & Pena, J. I. (2009). Credit spreads: An empirical analysis on the informational content of stocks, bonds, and CDS. Journal of Banking & Finance, 33, 2013-2025. https://doi.org/10.1016/j.iref.2013.10.003
Gonzalo, J., & Granger, C. (1995). Estimation of common long-memory components in cointegrated systems. Journal of Business & Economic Statistics, 13(1), 27-35. https://doi.org/10.1080/07350015.1995.10524576
Granger, C. (1969). Investigating causal relations by econometric models and cross-spectral methods. Econometrica: Journal of the Econometric Society, 37(3), 424-438. https://doi.org/10.2307/1912791
Greene, W. H. (2003). Econometric analysis. India: Pearson Education.Group of 20. (2009). Leaders’ statement: The Pittsburgh Summit. Retrieved from https://www.oecd.org/g20/summits/pittsburgh/G20-Pittsburgh-Leaders-Declaration.pdf
Gujarati, D. N. (2003). Basic econometrics (4th ed.). New York: McGraw-Hill.
Gyntelberg, J., Hördahl, P., Ters, K., & Urban, J. (2017). Arbitrage costs and the persistent non-zero CDS-bond basis: Evidence from intraday euro area sovereign debt markets. BIS Working Paper, No. 631.
Hassan, M. K., Ngene, G. M., & Suk-Yu, J. (2015). Credit default swaps and sovereign debt markets. Economic Systems, 39(2), 240-252. https://doi.org/10.1016/j.ecosys.2014.07.002
Hull, J. C., & White, A. D. (2000). Valuing credit default swaps I: No counterparty default risk. The Journal of Derivatives, 8(1), 29-40. https://doi.org/10.3905/jod.2000.319115
Hull, J., Predescu, M., & White, A. (2004). The relationship between credit default swap spreads, bond yields, and credit rating announcements. Journal of Banking & Finance, 28(11), 2789-2811. https://doi.org/10.1016/j.jbankfin.2004.06.010
Ito, T. (2016). The behaviour of sovereign CDS and government bond in the Euro zone crisis. International Journal of Monetary Economics and Finance, 9(2), 102-114. https://doi.org/10.1504/IJMEF.2016.076478
Jeffrey, M. W. (2009). Introductory econometrics: A modern approach. Canada: South-Western Cengage Learning.
Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica: Journal of the Econometric Society, 59(6), 1551-1580. https://doi.org/10.2307/2938278
Klenina, E., & Mateus, C. (2017). Global financial crisis and price discovery between credit default swaps premia and bond yield spreads. Retrieved from https://ssrn.com/abstract=3025003
Klieštik, T., & Cúg, J. (2015). Comparison of selected models of credit risk. Procedia Economics and Finance, 23, 356-361. https://doi.org/10.1016/S2212-5671(15)00452-9
Kollias, C., Mylonidis, N., & Paleologou, S. M. (2012). The nexus between exchange rates and stock markets: evidence from the euro-dollar rate and composite European stock indices using rolling analysis. Journal of Economics and Finance, 36(1), 136-147. https://doi.org/10.1007/s12197-010-9129-8
Kregzde, A., & Murauskas, G. (2015). Analysis of Lithuanian credit default swaps. Journal of Business Economics and Management, 16(5), 916-930. https://doi.org/10.3846/16111699.2014.890130
Lee, J., Naranjo, A., & Velioglu, G. (2017). When do CDS spreads lead? rating events, private entities, and firm-specific information flows. Journal of Financial Economics, Forthcoming. Retrieved from https://ssrn.com/abstract=2933052
Longstaff, F. A., Mithal, S., & Neis, E. (2003). The credit-default swap market: is credit protection priced correctly?. Working Paper, University of California.
Mylonidis, N., & Kollias, C. (2010). Dynamic European stock market convergence: Evidence from rolling cointegration analysis in the first euro-decade. Journal of Banking & Finance, 34(9), 2056-2064. https://doi.org/10.1016/j.jbankfin.2010.01.012
Ngene, G. M., Benefield, P., & Lynch, A. K. (2018). Asymmetric and nonlinear dynamics in sovereign credit risk markets. Journal of Futures Markets, 38(5), 563-585. https://doi.org/10.1002/fut.21896
Nguyen, N. B. (2017). The price discovery mechanism between sovereign bond and sovereign CDS market: Studies in selected countries. Asian Journal of Finance & Accounting, 9(2), 270-286. https://doi.org/10.5296/ajfa.v9i2.11636
Nyakabawo, W., Miller, S. M., Balcilar, M., Das, S., & Gupta, R. (2015). Temporal causality between house prices and output in the US: A bootstrap rolling-window approach. The North American Journal of Economics and Finance, 33, 55-73. https://doi.org/10.1016/j.najef.2015.03.001
Norden, L., & Weber, M. (2009). The co‐movement of credit default swap, bond and stock markets: an empirical analysis. European financial management, 15(3), 529-562. https://doi.org/10.1111/j.1468-036X.2007.00427.x
Palladini, G., & Portes, R. (2011). Sovereign CDS and bond pricing dynamics in the euro-area. NBER Working Paper, No. 17586. https://doi.org/10.3386/w17586
Swanson, N. R. (1998). Money and output viewed through a rolling window. Journal of Monetary Economics, 41(3), 455-474. https://doi.org/10.1016/S0304-3932(98)00005-1
Toda, H. Y., & Yamamoto, T. (1995). Statistical inference in vector autoregressions with possibly integrated processes. Journal of Econometrics, 66(1-2), 225-250. https://doi.org/10.1016/0304-4076(94)01616-8
Trujillo-Ponce, A., Samaniego-Medina, R., & Cardone-Riportella, C. (2014). Examining what best explains corporate credit risk: accounting-based versus market-based models. Journal of Business Economics and Management, 15(2), 253-276. https://doi.org/10.3846/16111699.2012.720598
Yin, K., Liu, Z., & Liu, P. (2017). Trend analysis of global stock market linkage based on a dynamic conditional correlation network. Journal of Business Economics and Management, 18(4), 779-800. https://doi.org/10.3846/16111699.2017.1341849
Zivot, E., & Andrews, D. (1992). Further evidence of the great crash, the oil-price shock and the unitroot hypothesis. Journal of Business and Economic Statistics, 10(3), 251-270. https://doi.org/10.1198/073500102753410372
Zhu, H. (2006). An empirical comparison of credit spreads between the bond market and the credit default swap market. Journal of Financial Services Research, 29(3), 211-235. https://doi.org/10.1007/s10693-006-7626-x
Ammer, J., & Cai, F. (2011). Sovereign CDS and bond pricing dynamics in emerging markets: Does the cheapest-to-deliver option matter?. Journal of International Financial Markets, Institutions and Money, 21(3), 369-387. https://doi.org/10.1016/j.intfin.2011.01.001
Andraz, J., Viegas, C. M., & Norte, N. M. (2015, 6-9 October). New insights on the long-term relationship between sovereign bonds debt and credit default swaps in Portugal. In IISES 2015: Proceedings of the International Academic Conference, International Institute of Social and Economic Sciences. Madrid, Spain.
Arce, O., Mayordomo, S., & Peña, J. I. (2013). Credit-risk valuation in the sovereign CDS and bonds markets: Evidence from the euro area crisis. Journal of International Money and Finance, 35, 124-145. https://doi.org/10.1016/j.jimonfin.2013.01.006
Baba, N., & Inada, M. (2007). Price discovery of credit spreads for Japanese mega-banks: Subordinated bond and CDS. IMES Discussion Paper, No. 2007-E-6.
Beber, A., Brandt, M. W., & Kavavejc, K. A. (2009). Flight-to-quality or flight-to-liquidity? Evidence from the Euro-Area bond market. Review of Financial Studies, 22(3), 925-957. https://doi.org/10.1093/rfs/hhm088
Blanco, R., Brennan, S., & Marsh, I. W. (2005). An empirical analysis of the dynamic relation between investment – grade bonds and credit default swaps. The Journal of Finance, 60(5), 2255-2281. https://doi.org/10.1111/j.1540-6261.2005.00798.x
Bowe, M., Klimaviciene, A. & Taylor, A. P. (2009, 4-7 March). Information transmission and price discovery in emerging sovereign credit risk markets. Paper presented at the Mid-West Finance Association Annual Conference, Chicago, USA.
Chan-Lau, J. A., & Kim, Y. S. (2004). Equity prices, credit default swaps, and bond spreads in emerging markets. IMF Working Paper, No. 04/27. https://doi.org/10.5089/9781451844559.001
Cossin, D., & Lu, H. (2005). Are European corporate bonds and default swap markets segmented?. Working Paper 153, FAME. https://doi.org/10.2139/ssrn.680464
Coudert, V., & Gex, M. (2013). The interactions between the credit default swap and the bond markets in financial turmoil. Review of International Economics, 21(3), 492-505. https://doi.org/10.1111/roie.12050
Coudert, V., & Gex, M. (2010). Credit default swap and bond markets: which leads the other. Banque de France-Financial Stability Review, 14, 161-167.
Delatte, A. L., Gex, M., & López-Villavicencio, A. (2012). Has the CDS market influenced the borrowing cost of European countries during the sovereign crisis?. Journal of International Money and Finance, 31(3), 481-497. https://doi.org/10.1016/j.jimonfin.2011.10.008
Delis, M. D., & Mylonidis, N. (2011). The chicken or the egg? A note on the dynamic interrelation between government bond spreads and credit default swaps. Finance Research Letters, 8(3), 163-170. https://doi.org/10.1016/j.frl.2010.09.005
Dickey, D. A., & Fuller, W. A. (1979). Distribution of the estimators for autoregressive time series with a unit root. Journal of the American statistical association, 74(366), 427-431. https://doi.org/10.2307/2286348
Duffie, D. (1999). Credit swap valuation. Financial Analysts Journal, 55(1), 73-87. https://doi.org/10.2469/faj.v55.n1.2243
European Central Bank. (2004). The Euro bond market study. ECB, Frankfurt.
Fontana, A., & Scheicher, M. (2016). An analysis of euro area sovereign CDS and their relation with government bonds. Journal of Banking & Finance, 62, 126-140. https://doi.org/10.1016/j.jbankfin.2015.10.010
Forte, S., & Pena, J. I. (2009). Credit spreads: An empirical analysis on the informational content of stocks, bonds, and CDS. Journal of Banking & Finance, 33, 2013-2025. https://doi.org/10.1016/j.iref.2013.10.003
Gonzalo, J., & Granger, C. (1995). Estimation of common long-memory components in cointegrated systems. Journal of Business & Economic Statistics, 13(1), 27-35. https://doi.org/10.1080/07350015.1995.10524576
Granger, C. (1969). Investigating causal relations by econometric models and cross-spectral methods. Econometrica: Journal of the Econometric Society, 37(3), 424-438. https://doi.org/10.2307/1912791
Greene, W. H. (2003). Econometric analysis. India: Pearson Education.Group of 20. (2009). Leaders’ statement: The Pittsburgh Summit. Retrieved from https://www.oecd.org/g20/summits/pittsburgh/G20-Pittsburgh-Leaders-Declaration.pdf
Gujarati, D. N. (2003). Basic econometrics (4th ed.). New York: McGraw-Hill.
Gyntelberg, J., Hördahl, P., Ters, K., & Urban, J. (2017). Arbitrage costs and the persistent non-zero CDS-bond basis: Evidence from intraday euro area sovereign debt markets. BIS Working Paper, No. 631.
Hassan, M. K., Ngene, G. M., & Suk-Yu, J. (2015). Credit default swaps and sovereign debt markets. Economic Systems, 39(2), 240-252. https://doi.org/10.1016/j.ecosys.2014.07.002
Hull, J. C., & White, A. D. (2000). Valuing credit default swaps I: No counterparty default risk. The Journal of Derivatives, 8(1), 29-40. https://doi.org/10.3905/jod.2000.319115
Hull, J., Predescu, M., & White, A. (2004). The relationship between credit default swap spreads, bond yields, and credit rating announcements. Journal of Banking & Finance, 28(11), 2789-2811. https://doi.org/10.1016/j.jbankfin.2004.06.010
Ito, T. (2016). The behaviour of sovereign CDS and government bond in the Euro zone crisis. International Journal of Monetary Economics and Finance, 9(2), 102-114. https://doi.org/10.1504/IJMEF.2016.076478
Jeffrey, M. W. (2009). Introductory econometrics: A modern approach. Canada: South-Western Cengage Learning.
Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica: Journal of the Econometric Society, 59(6), 1551-1580. https://doi.org/10.2307/2938278
Klenina, E., & Mateus, C. (2017). Global financial crisis and price discovery between credit default swaps premia and bond yield spreads. Retrieved from https://ssrn.com/abstract=3025003
Klieštik, T., & Cúg, J. (2015). Comparison of selected models of credit risk. Procedia Economics and Finance, 23, 356-361. https://doi.org/10.1016/S2212-5671(15)00452-9
Kollias, C., Mylonidis, N., & Paleologou, S. M. (2012). The nexus between exchange rates and stock markets: evidence from the euro-dollar rate and composite European stock indices using rolling analysis. Journal of Economics and Finance, 36(1), 136-147. https://doi.org/10.1007/s12197-010-9129-8
Kregzde, A., & Murauskas, G. (2015). Analysis of Lithuanian credit default swaps. Journal of Business Economics and Management, 16(5), 916-930. https://doi.org/10.3846/16111699.2014.890130
Lee, J., Naranjo, A., & Velioglu, G. (2017). When do CDS spreads lead? rating events, private entities, and firm-specific information flows. Journal of Financial Economics, Forthcoming. Retrieved from https://ssrn.com/abstract=2933052
Longstaff, F. A., Mithal, S., & Neis, E. (2003). The credit-default swap market: is credit protection priced correctly?. Working Paper, University of California.
Mylonidis, N., & Kollias, C. (2010). Dynamic European stock market convergence: Evidence from rolling cointegration analysis in the first euro-decade. Journal of Banking & Finance, 34(9), 2056-2064. https://doi.org/10.1016/j.jbankfin.2010.01.012
Ngene, G. M., Benefield, P., & Lynch, A. K. (2018). Asymmetric and nonlinear dynamics in sovereign credit risk markets. Journal of Futures Markets, 38(5), 563-585. https://doi.org/10.1002/fut.21896
Nguyen, N. B. (2017). The price discovery mechanism between sovereign bond and sovereign CDS market: Studies in selected countries. Asian Journal of Finance & Accounting, 9(2), 270-286. https://doi.org/10.5296/ajfa.v9i2.11636
Nyakabawo, W., Miller, S. M., Balcilar, M., Das, S., & Gupta, R. (2015). Temporal causality between house prices and output in the US: A bootstrap rolling-window approach. The North American Journal of Economics and Finance, 33, 55-73. https://doi.org/10.1016/j.najef.2015.03.001
Norden, L., & Weber, M. (2009). The co‐movement of credit default swap, bond and stock markets: an empirical analysis. European financial management, 15(3), 529-562. https://doi.org/10.1111/j.1468-036X.2007.00427.x
Palladini, G., & Portes, R. (2011). Sovereign CDS and bond pricing dynamics in the euro-area. NBER Working Paper, No. 17586. https://doi.org/10.3386/w17586
Swanson, N. R. (1998). Money and output viewed through a rolling window. Journal of Monetary Economics, 41(3), 455-474. https://doi.org/10.1016/S0304-3932(98)00005-1
Toda, H. Y., & Yamamoto, T. (1995). Statistical inference in vector autoregressions with possibly integrated processes. Journal of Econometrics, 66(1-2), 225-250. https://doi.org/10.1016/0304-4076(94)01616-8
Trujillo-Ponce, A., Samaniego-Medina, R., & Cardone-Riportella, C. (2014). Examining what best explains corporate credit risk: accounting-based versus market-based models. Journal of Business Economics and Management, 15(2), 253-276. https://doi.org/10.3846/16111699.2012.720598
Yin, K., Liu, Z., & Liu, P. (2017). Trend analysis of global stock market linkage based on a dynamic conditional correlation network. Journal of Business Economics and Management, 18(4), 779-800. https://doi.org/10.3846/16111699.2017.1341849
Zivot, E., & Andrews, D. (1992). Further evidence of the great crash, the oil-price shock and the unitroot hypothesis. Journal of Business and Economic Statistics, 10(3), 251-270. https://doi.org/10.1198/073500102753410372
Zhu, H. (2006). An empirical comparison of credit spreads between the bond market and the credit default swap market. Journal of Financial Services Research, 29(3), 211-235. https://doi.org/10.1007/s10693-006-7626-x