Fear or Fundamentals? Heterogeneous Beliefs in the European Sovereign CDS Market

Abstract

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, whilst some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.

Keywords: sovereign credit risk, European debt crisis, heterogeneous beliefs, momentum, CDS pricing

JEL Classification: F34, G01, G12, G15