Animal Spirits in the Euro Area Sovereign CDS Market
AbstractWe study the determinants for the sovereign credit default swap (CDS) spreads of five Euro-area countries (Greece, Ireland, Italy, Portugal, Spain) in the post-Lehman-Brothers period. We find that there are regime switches in the process of sovereign CDS spread changes. We consider three alternative empirical hypotheses associated with regime switches. Under the first hypothesis, there are rational sunspot equilibria. Under the second hypothesis, there is a unique fundamental equilibrium and the regime switching is caused by changes in policy makers' preferences. The third hypothesis relaxes the rational expectations assumption. Under this hypothesis, indicators of the market fundamentals are not always precise. They are better indicators if cognitive biases are small and the rational expectations economy is a good approximation for reality. However, if market uncertainties enlarge the cognitive biases, the market-based indicators of fundamentals are no longer precise. In this case, they are not useful for CDS pricing. We find that the first two hypotheses are difficult to fit the data and the third hypothesis provides a good explanation for the sovereign CDS spread dynamics in our sample.
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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9092.
Date of creation: Aug 2012
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Find related papers by JEL classification:
- F34 - International Economics - - International Finance - - - International Lending and Debt Problems
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
- P34 - Economic Systems - - Socialist Institutions and Their Transitions - - - Finance
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-09-03 (All new papers)
- NEP-EEC-2012-09-03 (European Economics)
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- Hans J. Blommestein, 2012. "The Debate over Sovereign Risk, Safe Assets, and the Risk-Free Rate: What are the Implications for Sovereign Issuers?," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 1(3), pages 55-70, September.
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