Sovereign CDS premia during the crisis and their interpretation as a measure of risk

The European government debt crisis began in May 2010 in the wake of Greece’s public finance problems, which sharply raised the yield demanded by investors from Greek government securities and finally prompted a request for international financial support. The distrust and strains spread rapidly to those euro area countries exhibiting greatest weakness, be it in their fiscal position or as a consequence of the macroeconomic imbalances which had built up. In autumn 2010 the Irish government also had to request financial assistance from the EU and the IMF in a fresh outbreak of tensions in sovereign risk markets. In April 2011 it was the turn of the Portuguese authorities to ask for help following a surge in the interest rates on their debt, although on this occasion the strains did not spread to other sovereigns as had occurred in previous cases. Perceptions of sovereign risk not only affect the public sector’s borrowing costs and its ability to refinance its debt on the markets, but also influence other economic agents’ borrowing costs. Consequently, it is important to have a tool to identify which factors are behind the recent increase in sovereign risk in euro area economies. Usually sovereign risk is determined by looking at the difference between the interest rates on sovereign bonds of the same maturity and characteristics issued by two different countries. Thus, what is actually being measured is a differential risk. Sovereign credit default swaps (CDSs) provide an alternative means for estimating individual sovereign risk. Before the crisis, sovereign CDS markets were not liquid enough to adequately measure developed economies’ sovereign risk. Following the outbreak of the crisis, however, there was a sharp increase in premium quotes and in trading volumes, which doubled. According to BIS data, in the first half of 2010 sovereign CDSs accounted for 13% of total CDSs, whereas at the beginning of the crisis (the second half of 2007) this percentage stood at only 6%. A CDS is an OTC contract (over-the-counter or non-exchange traded contract) which is very similar to insurance, whereby a buyer (of protection against sovereign risk) pays a fixed amount (the CDS premium) until maturity of the CDS or the occurrence of the “credit event”, which for a sovereign CDS would be the equivalent of the issuer State defaulting on its payment commitments. If this occurs before the CDS matures, the seller of the protection pays compensation to the buyer. Thus, the premium paid by the buyer of a CDS can be decomposed into two basic components [see, for example, Pan and Singleton (2008)]: an expected loss, which according to available estimates [Remolona et al. (2007), for example] tends to be relatively small and a sovereign risk premium. This article analyses recent developments in sovereign CDS premia in order to study which type of determinants favoured the increase in sovereign risk during the crisis. It contains four sections in addition to this introduction. Specifically, the first section explains the advantages of sovereign CDS premia compared with debt spreads for analysing sovereign risk in a situation such as the present one. Next, the results of several empirical exercises are presented in which changes in the CDS premia of a group of developed countries are decomposed into one part which relates to global factors and another part attributable to idiosyncratic factors. In the third section, the idiosyncratic component is separated into one part genuinely based on economic fundamentals and another part which can be associated with contagion and/or overreaction to movements in other sovereigns. Lastly, the main results are presented and the principal conclusions summarised.