The Determinants of Sovereign Credit Default Swap Spreads

Abstract

Sovereign Credit default swaps (sovereign CDS) have come into the limelight recently as a result of the economic quagmire of a crisis the global economy has faced since mid-2007. This thesis aims to shed light on the linkages between sovereign credit default swaps and other daily macroeconomic indicators of investor sentiment and risk aversion: from a global indicator point of view the Volatility Index more commonly know as the VIX; from a country-specific point of view, the sovereign bond markets and the country’s domestic currency value. This thesis assesses these linkages by assessing whether the VIX, the 5 year sovereign Bond yields for individual countries and the country’s domestic currency value in terms of the US Dollar, Granger-cause sovereign credit default swap spreads. These relationships are also assessed on a classification basis i.e. emerging versus frontier versus developed markets. A Granger Causality Vector Error Correction model is used to analyse these relationships. This study finds that there is a Granger-Casual relationship between these variables and most countries. However the economic significance of these relationships needs to be assessed in a broader context and is beyond the scope of this thesis. This thesis also focuses on the impact of non-daily macroeconomic such as GDP growth rate, inflation rates and so forth. The effect of non-macroeconomic data on sovereign CDS spreads such as legal origin, religion, ASEAN membership, EMU membership and so on is also considered in an ordered logistic regression. This study finds that non-macroeconomic variables have an impact on sovereign CDS pricing even after controlling for macroeconomic variables. This study also finds that variables that are important for the entire sample of countries are not necessarily important when the countries are assessed on a split cluster basis.