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The Implied Benchmark Rate in the Credit Default Swap Market of Sovereign Bonds

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Author Info
Li, Nan

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Abstract

Credit default swap(CDS) is a new developed derivative to insure the credit risk of an underlying entity. This paper investigates the correlation relationship of the CDS market of sovereign borrowers and sovereign bond market. Applying the formula in the paper of Hull et al.(2004), an implied default-free rate(also called benchmark rate) of CDS market is computed; its correlations with US treasury and LIBOR are tested respectively. The tests indicate that,in sovereign CDS market, the benchmark is more related with US treasury, although LIBOR has been used as the best approximation of market benchmark in both academia and industry. Therefore, this paper suggest the importance of US treasury to sovereign CDS market in measuring market's reference and searching for mispriced chance.In addition, a spuriously controversy result are found as rating-specific CDS benchmark rates are contrasted. A monotonic decrease of these benchmarks is clearly observed for the sovereigns with lower credit rating and higher default risk. The phenomenon is carefully explained and the main reason comes from the higher CDS rate than yield spread. This invites a further comparison of the price discovery processes in sovereign CDS market and the corresponding sovereign bond market.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 10014.

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Date of creation: 2004
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Handle: RePEc:pra:mprapa:10014

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G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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  1. Darrell Duffie & Lasse Heje Pedersen & Kenneth J. Singleton, 2003. "Modeling Sovereign Yield Spreads: A Case Study of Russian Debt," Journal of Finance, American Finance Association, vol. 58(1), pages 119-159, 02. [Downloadable!] (restricted)
  2. Houweling, P. & Vorst, A.C.F., 2003. "Pricing default swaps: empirical evidence," Econometric Institute Report EI 2003-51 Revision_Date:, Erasmus University Rotterdam, Econometric Institute. [Downloadable!]
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  3. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November. [Downloadable!] (restricted)
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