Savior or Sinner? Credit Default Swaps and the Market for Sovereign Debt

Author:

Iuliana Ismailescu   Blake Phillips  

Issue Date:

2011

Abstract(summary):

This paper analyzes the determinants and effects of credit default swap (CDS) trading initiation on sovereign bonds in 54 countries, focusing on market completeness, price efficiency and borrowing costs. We find that CDS initiation enhances market completeness for the majority of countries in our sample. Our results suggest that, for high default risk and low financial market openness countries, CDS initiation provides significant price efficiency benefits in the underlying market. In addition, we find that CDS initiation reduces risk premiums to investment-grade sovereigns while increasing borrowing costs for sub-investment-grade economies. CDS trading initiation is more likely following increases in local stock index volatility and the volatility risk premium and decreases in foreign currency reserves and the local currency exchange rate with the USD. Our results are robust to CDS initiation endogeneity controls constructed with these factors.

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58