This paper contributes to the general understanding of how sovereign CDS prices are formed by studying the information content of pricing errors generated by a non-arbitrage model. We implement a price-discrepancy measure in the spirit of the noise measure introduced by Hu et al. (2013) in the Treasury Bond market, and analyze its main determinants in panel data analysis. The main results show that sovereign CDS pricing errors are systematically related to higher bid-ask spreads. The evidence in this paper also suggests that exits of capital arbitrage during distressed periods, as measured by changes in net offsetting, can be associated to larger pricing errors in sovereign CDS from advanced economies, thereby supporting the main claims of the limit-to-arbitrage theories. These findings are robust for the most common CDS pricing models employed in the industry and different estimation techniques.
• We analyze the information content of sovereign CDS pricing errors
• A price discrepancy measure is estimated from the residuals of a non-arbitrage model
• This discrepancy measure reflects frictions such as illiquidity
• Exits of capital arbitrage in distress periods are linked to larger pricing errors
• Results are robust for the most common CDS pricing models
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