Economic policy uncertainty, CDS spreads, and CDS liquidity provision

• Author: Xinjie Wang,Zhaodong (Ken) Zhong,Weike Xu
• DOI: http://doi.org/10.1002/fut.21982
• Published date: 01 April 2019
• Date: 01 April 2019

Received: 4 February 2018

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Revised: 23 October 2018

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Accepted: 27 October 2018

DOI: 10.1002/fut.21982

RESEARCH ARTICLE

Economic policy uncertainty, CDS spreads, and CDS

liquidity provision

Xinjie Wang

1

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Weike Xu

2

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Zhaodong (Ken) Zhong

3

1

Department of Finance, Southern

University of Science and Technology,

Shenzhen, China

2

Department of Finance, College of

Business, Clemson University, Clemson,

South Carolina

3

Department of Finance and Economics,

Rutgers Business School, Rutgers

University, Piscataway, New Jersey

Correspondence

Zhaodong (Ken) Zhong, Department of

Finance and Economics, Rutgers Business

School, Rutgers University, Piscataway,

NJ 08854, USA.

Email: zdzhong@business.rutgers.edu

Funding information

Southern University of Science and

Technology, Grant/Award Number:

Startup Grant (24‐Y01246210)

Abstract

Using a news‐based index of economic policy uncertainty (EPU), we find that

EPU is positively associated with credit default swap (CDS) spreads and

negatively associated with the number of liquidity providers in the CDS market.

A 10% increase in EPU leads to an 8.4% increase in CDS spreads and a 4.0%

decrease in the number of liquidity providers. Furthermore, the effects of EPU

are persistent and robust after controlling for macroeconomic variables. Our

results are also robust to different econometric methodologies. Overall, our

findings suggest that, when EPU is high, investors find credit protection more

costly and difficult to purchase.

KEYWORDS

credit default swap, liquidity provision, market depth, policy uncertainty

JEL CLASSIFICATION

E44, G10, G12, G18

1

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INTRODUCTION

Businesses operate in an environment with a significant amount of uncertainty in economic and regulatory policies. For

instance, a political debate in the United States Congress about the appropriate level of government spending led to the

debt ceiling crisis in 2011, when former Secretary of the Treasury Timothy Geithner warned of catastrophe if Congress

failed to act: “Failure to raise the limit would precipitate a default by the United States. Default would effectively

impose a significant and long‐lasting tax on all Americans and all American businesses and could lead to the loss of

millions of American jobs.”

1

Recent empirical studies show that economic policy uncertainty (EPU) can have adverse effects on financial

markets, such as increasing stock price volatility, depressing corporate investment, and restraining bank credit growth

(e.g., Baker, Bloom, & Davis, 2016 [hereafter, BBD]; Bordo, Duca, & Koch, 2016; Gulen & Ion, 2016). As a result of these

adverse effects, the credit risk of corporations, as measured by CDS spreads, could rise significantly following a spike in

EPU. Furthermore, both theoretical and empirical studies (e.g., Brunnermeier & Pedersen, 2009; Chung &

Chuwonganant, 2014; Nagel, 2012) show that uncertainty reduces liquidity provision in financial markets. For

example, heightened EPU may induce additional margin requirements, which could force market makers to withdraw

liquidity provision from the market. Therefore, EPU could reduce liquidity provision in the CDS market. The empirical

evidence on these issues, however, is scarce. In this paper, we attempt to fill this gap by examining the impact of EPU

on CDS spreads and liquidity provision in the CDS market.

J Futures Markets. 2019;39:461–480. wileyonlinelibrary.com/journal/fut © 2018 Wiley Periodicals, Inc.

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1

For details, see “Secretary Geithner Sends Debt Limit Letter to Congress,”U.S. Department of the Treasury, January 6, 2011. Retrieved from https://www.treasury.gov/connect/blog/Pages/Secretary‐

Geithner‐Sends‐Debt‐Limit‐Letter‐to‐Congress‐12‐26.aspx.

We first employ a news‐based index of EPU developed by BBD (2016) to quantify the effect of EPU on the CDS

spreads of US firms from January 2001 to October 2016.

2

After controlling for the fundamental determinants of credit

risk, we find that EPU is positively associated with CDS spreads, indicating that policy uncertainty increases the

credit risk of firms. We conduct further analyses using the components of the BBD index. We find that all

components are positively associated with CDS spreads. In particular, the news component has the most significant

explanatory power for CDS spreads. Our results show that a 10% increase in the BBD index leads to an 8.4% increase

in CDS spreads. To put this magnitude in perspective, the BBD index rose from 197.9 in July 2011 to 245.1 (21%

increase) in August 2011, in response to the debt ceiling dispute, which indicates an upward shift of 31 basis points

(18%) in CDS spreads.

Second, we investigate the effect of policy uncertainty on liquidity provision in the CDS market. Following Qiu and

Yu (2012), we use the number of market makers providing CDS quotes as a proxy for liquidity provision. We find a

strong negative relation between EPU and the number of liquidity providers. A 10% increase in EPU is related to a 4.0%

decline in the number of market makers in the CDS market. Given that, on average, about 7.3 market makers are

present in the CDS market, this negative effect of EPU on liquidity provision is quite economically significant. For

example, suppose that the BBD index increases by 100%, then CDS liquidity provision would decline by 40%, which

corresponds to a reduction of three liquidity providers in the CDS market. The negative relation between EPU and

liquidity provision is consistent with Brunnermeier and Pedersen’s (2009) predictions and Chung and Chuwonganant’s

(2014) finding that market liquidity decreases with high levels of market‐wide uncertainty. Our results are also in line

with Nagel’s (2012) view that market liquidity evaporates during financial crises because liquidity providers require

greater returns. Additionally, we find that the negative association between EPU and the CDS liquidity provision is

robust using the components of the BBD index.

Third, we conduct additional tests to examine the persistence and time‐variation of the effects of EPU on CDS

spreads and liquidity provision. Gulen and Ion (2016) show that policy uncertainty significantly affects a firm’s

investments for up to 2 years. Consistent with their findings, we document that the effects of the BBD index on CDS

spreads and liquidity provision are persistent for up to eight quarters. Additionally, we find that the effect of policy

uncertainty on CDS spreads is more pronounced during recessionary periods, which is consistent with Pástor and

Veronesi (2013) prediction.

Fourth, we investigate whether or not the impact of policy uncertainty on CDS spreads is heterogeneous across

industries and firms. This test is motivated by BBD (2016), who document that policy uncertainty reduces

investment and employment and raises stock price volatility in policy‐sensitive sectors, such as defense and

finance. We find evidence that the effect of policy uncertainty on CDS spreads is indeed more pronounced among

firms in the finance and defense industries. Furthermore, using BBD’s(2016)measureoffirms’exposure to

government purchases of goods and services, we conduct a cross‐sectional analysis and demonstrate that firms

with greater exposure to government purchases experience a larger increase in CDS spreads when faced with a

high level of EPU.

Finally, we conduct a number of robustness checks using different econometric methodologies. First, to deal with

the heterogeneity issue in panel regressions, we use two econometric methods: Estimating marginal treatment effects

(MTEs) using the method in Heckman, Urzua, and Vytlacil (2006) and employing the latent instrumental variable

(LIV) approach of Park and Gupta (2012).

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The results using these two econometric methods are consistent with our

main results, thus giving credence to our conclusions. Second, to address a measurement error concern that the BBD

index may capture economic uncertainty that is not related to policy but still affects the credit risk of firms, we utilize

the similarities between the US and Canadian economies. Given the tight link between the two economies, the

shocks that impact general economic uncertainty in the United States most likely also affect general economic

uncertainty in Canada. We remove the part of the BBD index that is associated with general economic uncertainty by

extracting the residual component of the US EPU orthogonal to the Canadian EPU and show that the effects of the

residual EPU on CDS spreads and liquidity provision are statistically significant only for US firms. Finally, to control

for the possible simultaneity of EPU and CDS spreads or market depth, we also use the generalized method of

moments (GMM) estimator developed for the dynamic panel regressions in Arellano and Bond (1991), Arellano and

2

The BBD index is a weighted average of different components. The first and most important component is based on the number of newspaper articles containing keywords relevant to policy

uncertainty (EPU News). The second component is policy uncertainty related to future changes in tax code (EPU Tax). The third component captures the policy uncertainty associated with future

fiscal policies (EPU GOV) and monetary policies (EPU CPI), respectively. For more details on the construction of the BBD index and its subcomponents, see BBD (2016).

3

For a review, see, for example, Nandialath, Dotson, and Durand (2014).

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WANG ET AL.