The EU Sovereign CDS Ban: Asset Pricing and Welfare Implications under Optimal Beliefs

Abstract

Trading in the CDS market in this paper occurs because irrational investors have optimal beliefs about the default state of the economy, those investors tend to be overly optimistic that default is less likely. Since the imposition of the CDS ban on member states of the European Union in 2012, not only are investors forced to share risk through an incomplete capital market, optimal beliefs about default can also change. I show two sets of asset pricing implications can occur, one in which stock market values increase and countries' borrowing rates decrease after the ban is imposed, and one in the opposite direction. I find empirical support for the former, and also show the CDS ban is welfare improving in this case. While rational investors would benefit from lifting the ban, the gain is not sufficient to compensate irrational investors for their utility loss.

Keywords: Sovereign Debt, Credit Default Swaps, EU Regulation 236, Heterogeneous Beliefs, Incomplete Markets

JEL Classification: G12, G15, G18, H63