Bending the curve: How nonlinear relationships between CDS spreads and default risk redefine Greece's sovereign debt story

This paper examines whether sovereign risk pricing is linear or regime-dependent by analyzing the joint behavior of Greek sovereign bond yields and CDS spreads during the Eurozone crisis. Strong nonlinear dependence is documented using BDS tests applied to baseline residuals, rejecting independent and identically distributed behavior across embedding dimensions and distance thresholds. Linear, quadratic, and threshold regression specifications are then estimated to identify regime-dependent sensitivities. While the baseline model confirms a tight positive linkage between yields and CDS spreads, nonlinear specifications reveal pronounced convexity and discrete regime shifts. Once yields breach empirically identified credibility thresholds, CDS sensitivity increases sharply, indicating expectation-driven amplification rather than proportional fundamentals-based repricing. Event-specific thresholds around major policy episodes further show that official interventions may either intensify instability—when perceived as reactive or ambiguous—or stabilize expectations when credible and conditional. These results imply that sovereign stress is governed by credibility-driven nonlinear dynamics and that threshold-based monitoring of yields and CDS spreads can serve as an effective early-warning tool. Policy timing, clarity, and conditionality emerge as central elements in preventing self-reinforcing market stress and contagion.