Credit Default Swaps and the Market for Sovereign Debt

Abstract

We analyze the determinants and effects of credit default swap (CDS) trading initiation on sovereign bonds. For high default risk countries, CDS initiation provides significant price efficiency benefits in the underlying market. CDS initiation also reduces average risk premiums, with reductions in borrowing costs likewise increasing with default risk. CDS trading initiation is more likely following increases in local equity index volatility, the volatility risk premium, or index spreads for regional or global CDS markets and decreases in a country’s ability to service foreign debt. Our results are robust to selection bias controls based on these factors.

Keywords: sovereign bond, market efficiency, borrowing costs, credit default swap, credit derivative

JEL Classification: G12, G14, G15, G20