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Sovereign CDS and Bond Pricing Dynamics in the Euro-area

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  • Giorgia Palladini
  • Richard Portes

Abstract

This analysis tests the price discovery relationship between sovereign CDS premia and bond yield spreads on the same reference entity. The theoretical no-arbitrage relationship between the two credit spreads is confronted with daily data from six Euro-area countries over the period 2004-2011. As a first step, the supposed non stationarity of the two series is verified. Then, we examine whether the non-stationary CDS and bond spreads series are bound by a cointegration relationship. Overall the cointegration analysis confirms that the two prices should be equal to each other in equilibrium, as theory predicts. Nonetheless the theoretical value [1, -1] for the cointegrating vector is rejected, meaning that in the short run the cash and synthetic market's valuation of credit risk differ to various degrees. The VECM analysis suggests that the CDS market moves ahead of the bond market in terms of price discovery. These findings are further supported by the Granger Causality Test: for most sovereigns in the sample, past values of CDS spreads help to forecast bond yield spreads. Short-run deviations from the equilibrium persist longer than it would take for participants in one market to observe the price in the other. That is consistent with the hypothesis of imperfections in the arbitrage relationship between the two markets.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17586.

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Date of creation: Nov 2011
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Handle: RePEc:nbr:nberwo:17586

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Cited by:
  1. Georgoutsos, Dimitris A. & Migiakis, Petros M., 2013. "Heterogeneity of the determinants of euro-area sovereign bond spreads; what does it tell us about financial stability?," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 4650-4664.
  2. Carmen Broto & Gabriel Perez-Quiros, 2013. "Disentangling contagion among sovereign cds spreads during the european debt crisis," Banco de Espa�a Working Papers 1314, Banco de Espa�a.
  3. Alter, Adrian & Beyer, Andreas, 2013. "The dynamics of spillover effects during the European sovereign debt crisis," Working Paper Series 1558, European Central Bank.
  4. Alter, Adrian & Beyer, Andreas, 2012. "The dynamics of spillover effects during the European sovereign debt turmoil," CFS Working Paper Series 2012/13, Center for Financial Studies (CFS).
  5. Ratner, Mitchell & Chiu, Chih-Chieh (Jason), 2013. "Hedging stock sector risk with credit default swaps," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 18-25.
  6. Giovanni Calice & RongHui Miao & Filip Sterba & Borek Vasicek, 2013. "Short-Term Determinants of the Idiosyncratic Sovereign Risk Premium: A Regime-Dependent Analysis for European Credit Default Swaps," Working Papers 2013/13, Czech National Bank, Research Department.

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