Speculation in European Sovereign Debt Markets

Abstract

European sovereign debt markets have been under scrutiny ever since the sovereign debt crisis of 2009. In this paper, we decompose bond and CDS spreads into fundamental and non-fundamental parts by means of a heterogeneous agent model. The model contains arbitrageurs who make use of the arbitrage opportunities between bond and CDS markets, speculators who trade on price trends, as well as liquidity traders. We find that bond markets are driven for 80% by liquidity trading, 13% by credit news, and only 5.4% by speculation. The CDS market is for 49% driven by credit news, 45% liquidity trading, and 5.5% speculation. The relative importance of the different types of agents varies over time, though.

Keywords: Credit risk, sovereign bonds, CDS, heterogeneous agent models

JEL Classification: C32, C5, G15