Do Sovereign Credit Default Swaps Represent a Clean Measure of Sovereign Default Risk? A Factor Model Approach

48 Pages Posted: 15 Mar 2012 Last revised: 29 Jan 2013

See all articles by Saad Badaoui

Saad Badaoui

EDHEC Business School/EDHEC Risk Institute

Lara Cathcart

Imperial College Business School

Lina El-Jahel

University of Auckland Business School

Date Written: January 24, 2013

Abstract

In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.

Keywords: Sovereign CDS spreads, Default and Liquidity Intensities, Grid Search Method and Exponential Affine Models

JEL Classification: G00, G12, G13

Suggested Citation

Badaoui, Saad and Cathcart, Lara and El-Jahel, Lina, Do Sovereign Credit Default Swaps Represent a Clean Measure of Sovereign Default Risk? A Factor Model Approach (January 24, 2013). Available at SSRN: https://ssrn.com/abstract=2021997 or http://dx.doi.org/10.2139/ssrn.2021997

Saad Badaoui (Contact Author)

EDHEC Business School/EDHEC Risk Institute ( email )

10 Fleet Place
Ludgate
London, DC EC4M 7RB
United Kingdom

Lara Cathcart

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 (0) 20 7594 9126 (Phone)
+44 (0) 20 7594 9189 (Fax)

Lina El-Jahel

University of Auckland Business School ( email )

12 Grafton Rd
Private Bag 92019
Auckland, 1010
New Zealand

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