Characterizing Sovereign Credit Risk Interdependencies: Evidence from the Credit Default Swap Market
33 Pages Posted: 10 Mar 2016
Date Written: January 30, 2016
We exploit emerging market sovereign CDS spreads to examine the reaction of sovereign credit risk to changes in country-specific and global financial factors. Utilizing a VAR model fitted with DCC GARCH, we find that comovements of spreads generally exhibit significant time-varying correlations, suggesting that spreads are commonly affected by global financial factors. We construct 19 country-specific commodity price indexes to instrument for country terms of trade, obtaining striking novel results. Our commodity price indexes account for significant variation in CDS spreads, controlling for global financial factors. In addition, sovereign spreads are found to be related to U.S. stock market returns and the VIX volatility risk premium global factors. Notwithstanding, our results suggest that terms of trade and commodity prices have a statistically and economically significant effect on the sovereign credit risk of emerging economies. Our results apply broadly to investors, financial institutions and policy makers motivated to utilize profitable factors in global portfolios.
Keywords: Credit Default Swaps (CDS), Commodity Prices, Terms of Trade, DCC GARCH, Vector Autoregressive (VAR)
JEL Classification: F34, G13, G12, G15, P34
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