The Drivers of Sovereign CDS Spread Changes: Local Versus Global Factors

Date01 August 2017
Published date01 August 2017
The Financial Review 52 (2017) 435–457
The Drivers of Sovereign CDS Spread
Changes: Local Versus Global Factors
Ann Marie Hibbert
West Virginia University
Ivelina Pavlova
University of Houston-Clear Lake
Weuse daily data for a panel of 34 countries to investigate regional differences in sovereign
credit default swaps (CDS) spread determinants and the significance of local versus global
market factors. Similar to prior studies, we find a high level of commonality among CDS
spreads, but our results show that this effect is stronger in Latin American CDS. The results of
our quantile panel regression model show that although global forces drive spreads across the
conditional distribution, changes in credit ratings are significant in explaining CDS spreads
only in the upper quantiles. We also confirm the existence of regional differences in spread
Keywords: sovereign CDS, CDS spread determinants, quantile panel regression
JEL Classifications: G15, G23, H63, C23
Corresponding author: Department of Finance, College of Business and Economics, West Virginia
University,P.O. Box 6025, Morgantown, WV 26506; Phone: 304-293-2447, Fax: 304-293-3274; E-mail:
Wewould like to thank the Editor and two anonymous referees for helpful comments and suggestions. We
also acknowledge helpful comments from seminar participants at the Eastern Finance Association (EFA)
2016 meeting in Baltimore, MD.
C2017 The Eastern Finance Association 435
436 A. M. Hibbert and I. Pavlova/The Financial Review 52 (2017) 435–457
1. Introduction
The recent debt crisis in the European Union (EU) underscores the impor-
tance of using credit instruments to hedge against losses from sovereign default
or debt restructuring. Sovereign credit default swaps (CDS) are derivatives that of-
fer protection against losses on sovereign debt from credit events. Sovereign CDS
can be used for arbitrage, hedging, or speculation. CDS buyers can either hedge
exposure in the underlying sovereign bonds or hedge exposure in other assets, for ex-
ample, bank bonds, in the reference country.1Speculative positions in sovereign
CDS are taken on a naked basis, that is, without a position in the underlying
The sovereign CDS market has grown at a fast pace since 2005, with the no-
tional amount exceeding $3 trillion in 2013 (Fig. 1), and later declining but re-
maining close to $2 trillion in 2016. The rapid growth in credit derivatives’ no-
tional value has drawn questions about their possible destabilizing effects as well
as what determines the changes in sovereign CDS spreads. The increased volatil-
ity in European debt markets after the worsening situation in Greece in 2010 and
2011 prompted EU governments to express concerns about the role of CDS specula-
tion in intensifying price declines and raising borrowing costs in already struggling
EU periphery countries. As a result, naked sovereign CDS trading was prohibited
by the EU in November 2012. Recent reports by the International Monetary Fund
(IMF), however, do not find the ban justified and warn about decreased market
The spotlight on sovereign CDS markets as a possible destabilizing factor has
also prompted an increase in studies on the determinants of sovereign CDS prices.
Longstaff, Pan, Pedersen and Singleton (2011) is among the few studies that de-
compose sovereign CDS drivers into country-specific and global macroeconomic
factors. They show that credit spreads are more related to U.S. equity market and
global financial variables than to country-specific economic measures. Longstaff,
Pan, Pedersen and Singleton (2011) find that the first principal component accounts
for a large portion of the variability in sovereign spreads, and that in times of market
turbulence this factor is highly (inversely) correlated with the Chicago Board Op-
tions Exchange (CBOE) volatility index (VIX), having a correlation coefficient of
75%. Pan and Singleton (2008) also show a strong association of the spreads of
Mexico, Turkey, and Korea with the VIX. Other studies in the same strand of the
literature discussing the importance of global determinants of sovereign spreads are
those by Ang and Longstaff (2013); Augustin and Tedongap (2016); Aizenman,
Hutchison and Jinjarak (2013); Fender, Hayo and Neuenkirch (2012); and
1IMF Global Financial Stability Report, Old Risks, New Challenges, April 2013.
2IMF Global Financial Stability Report, Old Risks, New Challenges, April 2013.

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