Sovereign CDS and Bond Pricing Dynamics in Emerging Markets: Does the Cheapest-to-Deliver Option Matter?

49 Pages Posted: 28 Dec 2007

See all articles by John Ammer

John Ammer

U.S. Federal Reserve Board of Governors

Fang Cai

Federal Reserve Board

Date Written: December 2007

Abstract

We examine the relationships between credit default swap (CDS) premiums and bond yield spreads for nine emerging market sovereign borrowers. We find that these two measures of credit risk deviate considerably in the short run, due to factors such as liquidity and contract specifications, but we estimate a stable long-term equilibrium relationship for most countries. In particular, CDS premiums tend to move more than one-for-one with yield spreads, which we show is broadly consistent with the presence of a significant cheapest-to-deliver (CTD) option. In addition, we find a variety of cross-sectional evidence of a CTD option being incorporated into CDS premiums. In our analysis of the short-term dynamics, we find that CDS premiums often move ahead of the bond market. However, we also find that bond spreads lead CDS premiums for emerging market sovereigns more often than has been found for investment-grade corporate credits, consistent with the CTD option impeding CDS liquidity for our riskier set of borrowers. Furthermore, the CDS market is less likely to lead for sovereigns that have issued more bonds, suggesting that the relative liquidity of the two markets is a key determinant of where price discovery occurs.

Keywords: Credit derivatives, sovereign bonds, yield spreads, emerging markets, liquidity, options

JEL Classification: G10, G14, G15

Suggested Citation

Ammer, John Matthew and Cai, Fang, Sovereign CDS and Bond Pricing Dynamics in Emerging Markets: Does the Cheapest-to-Deliver Option Matter? (December 2007). FRB International Finance Discussion Paper No. 912, Available at SSRN: https://ssrn.com/abstract=1079082 or http://dx.doi.org/10.2139/ssrn.1079082

John Matthew Ammer (Contact Author)

U.S. Federal Reserve Board of Governors ( email )

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202-452-2349 (Phone)
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Fang Cai

Federal Reserve Board ( email )

Office of Financial Stability Policy and Research
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Washington, DC 20551
United States
202-452-3540 (Phone)
202-263-4850 (Fax)

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