A Macrofinance View of U.S. Sovereign CDS Premiums

39 Pages Posted: 24 Oct 2016

See all articles by Mikhail Chernov

Mikhail Chernov

UCLA Anderson

Lukas Schmid

University of Southern California - Marshall School of Business

Andrés Schneider

Board of Governors of the Federal Reserve System

Date Written: October 2016

Abstract

Premiums on U.S. sovereign CDS have risen to persistently elevated levels since the financial crisis. In this paper, we ask whether these premiums reflect the probability of a U.S. fiscal default, namely a state in which budget balance can no longer be restored by further raising taxes or eroding the real value of debt by raising inflation. To that end, we develop an equilibrium macrofinance model of the U.S. economy, in which the fiscal and monetary policy stance jointly endogenously determine nominal debt, taxes, inflation and growth. While U.S. CDS cannot be valued using standard replication arguments, we show how in our equilibrium model, CDS premiums reflect endogenous risk adjusted fiscal default probabilities. A calibrated version of the model is quantitatively consistent with high premiums on U.S. sovereign CDS.

Keywords: credit default swaps, recursive preferences, sovereign default

JEL Classification: E43, E44, E52, G12, G13

Suggested Citation

Chernov, Mikhail and Schmid, Lukas and Schneider, Andrés, A Macrofinance View of U.S. Sovereign CDS Premiums (October 2016). CEPR Discussion Paper No. DP11576, Available at SSRN: https://ssrn.com/abstract=2858239

Mikhail Chernov (Contact Author)

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Lukas Schmid

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd, HOH 431
Los Angeles, CA California 90089-1424
United States

Andrés Schneider

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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