02 April 2013

Bundesbank: Sovereign default swap market efficiency and country risk in the eurozone

Summary

This paper uses CDS spread changes as a measure for the informational efficiency of the sovereign markets and CDS spread volatilities as a proxy for persistency of country risks. Specifically, it tests whether the dependence of consecutive observations dies out slowly over time ("long memory"). The authors firstly show that there is no evidence of such behaviour of CDS spread changes for any of the 10 eurozone countries in their sample. This indicates that, despite the financial crisis and uncertainty of financial markets, price discovery processes satisfy the minimum requirements for a weak form of market efficiency for sovereign CDSs, i.e. recent CDS spread changes cannot be predicted with past CDS spread changes.

Second, there is strong evidence of long memory for volatility patterns of spread changes for six out of 10 countries. Specifically, the authors observe Greece, Portugal, Ireland, Italy, Spain and Belgium to demonstrate such behaviour. This shows that economies in the eurozone, which have been particularly affected by the financial and the sovereign debt crisis, are exposed to high uncertainty risk not only for a short period but over a persistent horizon.

Third, the authors illustrate that CDS volatility is causal to CDS levels, indicating that uncertainty in CDS markets translates into higher risk premia for sovereign risk. Finally, the authors highlight the existence of a co-movement of CDS spread changes for all countries, which is more explicit among peripheral economies.

These results have implications on selecting sovereign risk measures: Increased global risk aversion and the uncertainty about future sovereign debt market conditions have caused an increase in sovereign CDS volatility, which has been shown to be a meaningful measure of sovereign risk.

Full paper

© Deutsche Bundesbank