Working Paper: NBER ID: w17586
Authors: Giorgia Palladini; Richard Portes
Abstract: This analysis tests the price discovery relationship between sovereign CDS premia and bond yield spreads on the same reference entity. The theoretical no-arbitrage relationship between the two credit spreads is confronted with daily data from six Euro-area countries over the period 2004-2011. As a first step, the supposed non stationarity of the two series is verified. Then, we examine whether the non-stationary CDS and bond spreads series are bound by a cointegration relationship. Overall the cointegration analysis confirms that the two prices should be equal to each other in equilibrium, as theory predicts. Nonetheless the theoretical value [1, -1] for the cointegrating vector is rejected, meaning that in the short run the cash and synthetic market's valuation of credit risk differ to various degrees. The VECM analysis suggests that the CDS market moves ahead of the bond market in terms of price discovery. These findings are further supported by the Granger Causality Test: for most sovereigns in the sample, past values of CDS spreads help to forecast bond yield spreads. Short-run deviations from the equilibrium persist longer than it would take for participants in one market to observe the price in the other. That is consistent with the hypothesis of imperfections in the arbitrage relationship between the two markets.
Keywords: CDS; bond pricing; price discovery; sovereign risk
JEL Codes: F34; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| CDS spreads (G12) | Bond yields (G12) |
| Bond yields (G12) | CDS spreads (G12) |
| CDS spreads (G12) | Bond yield spreads (G12) |
| CDS market (G10) | Bond market (G10) |
| CDS spreads (G12) | Bond yields (G12) |