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

• DOI: http://doi.org/10.1111/fire.12140
• Date: 01 August 2017
• Published date: 01 August 2017
• Author: Ivelina Pavlova,Ann Marie Hibbert

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

Abstract

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

determinants.

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:

amhibbert@mail.wvu.edu.

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.

C2017 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

asset.

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

liquidity.2

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

others.

1IMF Global Financial Stability Report, Old Risks, New Challenges, April 2013.

2IMF Global Financial Stability Report, Old Risks, New Challenges, April 2013.