Credit Default Swaps and Sovereign Debt Markets
Networks Financial Institute Working Paper 2011-WP-03
39 Pages Posted: 8 Mar 2011
Date Written: March 1, 2011
This study investigates the link between price discovery dynamics in sovereign credit default swaps (CDS) and bond markets and degree of financial integration of emerging markets. Using CDS and sovereign bond spreads, the price discovery mechanism was tested using a vector error correction model. Financial integration is measured using news-based methods. We find that sovereign CDS and bond markets are co-integrated. In 57 percent of times, the CDS market leads in price discovery by adjusting before bonds to new information regarding credit risk. In 29 percent of times, bond markets are sources of price discovery. We also find a strong positive correlation of 0.84 between degree of financial integration and bond market information share. The evidence suggests that changes in sovereign credit risk and bond yields are significantly influenced by common external (global) factors while country specific factors play an insignificant role.
Keywords: Price discovery, financial integration, CDS, sovereign bonds, credit risk
JEL Classification: C13, E43, G15
Suggested Citation: Suggested Citation