Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis

Review of Finance, Forthcoming

40 Pages Posted: 19 Mar 2010 Last revised: 27 Apr 2011

See all articles by Stephan Dieckmann

Stephan Dieckmann

University of Pennsylvania - Finance Department

Thomas Plank

University of Pennsylvania - Finance Department

Date Written: February 24, 2011

Abstract

What determines the price of insurance against default of advanced economies? Our laboratory to answer this question is the credit default swap (CDS) market on government debt of 18 advanced economies. The price of credit protection on these countries shows a strong degree of co-movement, has severely increased since the beginning of the financial crisis, and remains at elevated levels. We document that the state of a country's domestic financial system, and since the beginning of the crisis also the state of the world financial system have strong explanatory power for the behavior of CDS spreads, and that the magnitude of this impact depends on the relative importance of a country's financial system pre-crisis. Furthermore, it matters whether a country is a member of the Economic and Monetary Union of the European Union (EMU), in that their sensitivities to the health of the financial system are higher compared to non-EMU members. While one would expect the unconditional risk of default to be low in case of advanced economies, our results suggest the presence of an important economic channel in adverse economic times: a private-to-public risk transfer through which market participants incorporate their expectations about financial industry bailouts and the potential burden of government intervention.

Keywords: Sovereign Credit Risk, Private-to-Public Risk Transfer, Financial Crisis

JEL Classification: F30, G01

Suggested Citation

Dieckmann, Stephan and Plank, Thomas, Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis (February 24, 2011). Review of Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1572118

Stephan Dieckmann (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Thomas Plank

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

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