* The discussion here in good part summarises research that is joint with Giorgia Palladini and is available as CEPR Discussion Paper 8651, “Sovereign CDS and Bond Price Dynamics in the Eurozone”, November 2011, and financed by PEGGED. We used data from CMA for our empirical analysis. But Giorgia Palladini is not responsible for my interpretations of our results, nor for my assessment of the role of naked CDSs.
sovereign CDSs dropped to 5% at the end of 2007, with contracts written on emerging economies accounting for over 90% of the global volume of trade. Since the Eurozone debt crisis began, however, the share of sovereign CDSs has risen sharply. At the end of May 2010, the gross notional value of the whole CDS market accounted for $14.5 trillion, with about 2.1 million contracts outstanding. The sovereign segment of the market reached $2.2 trillion, with 0.2 million contracts. Hedge funds, global investment banks, and non-resident fund managers seem to be the most active participants in the market.
Before the introduction of credit derivatives, there was no way to isolate credit risk from the underlying bond or loan. The CDS market has filled this gap, and it may be regarded as a useful financial innovation, subject to (a) verification that it performs this function efficiently; (b) assurance that it has not been transformed into a highly speculative market in ‘naked CDSs’ that perform no hedging function and serve in particular merely to make bets on the future of financial firms and sovereigns that can destabilise them. We address these issues in turn.
The CDS market has drawn increasing attention from practitioners, regulators, and even politicians. Yet much of the existing research used data from the early period of the market’s development, and there is little focus on the segment of greatest policy interest, the Eurozone sovereign bond market. That policy focus may itself be misplaced, because the CDS market may be more destabilising for financial firms than for sovereigns.
Regardless, it was the politicians’ concern about the role of CDSs on Greece starting in spring 2010 that drove subsequent action by the European Commission and the European Parliament.
As Duffie (1999) and related literature point out, a theoretical no-arbitrage condition between the cash and synthetic price of credit risk should drive investment decisions and tie up the two credit spreads in the long run. Insofar as credit risk is what they price, cash and CDS market prices should reflect an equal valuation, in equilibrium. If in the short run they are affected by factors other than credit risk, such elements may
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partially obscure the comovement between bond yield spreads and CDS premia. The first contribution of our research has therefore been to check the accuracy of credit risk pricing in the CDS market. Does the market perform an important role in providing useful information to market participants and other observers?
We proceed by comparing the theoretically implied CDS premia with the ones established by the market. The existence of a stable relationship between the two credit spreads implies a long-run connection between bonds and CDS contracts on the same reference entity, in our case a sovereign. On the one hand, this rules out the possibility that credit risk is priced in unrelated ways in the derivative and cash markets. On the other, we cannot discard the hypothesis that large common pricing components rather than credit risk affect both prices to some extent.
Our research has also addressed the relative efficiency of credit risk pricing in the bond and CDS market. Here we are concerned with the ‘price discovery’ relationship between CDS and bond yield spreads. In particular, can the CDS market anticipate the bond market in pricing, or does it merely adapt to the cash market valuation of credit risk?
Several recent papers study the credit derivative markets. The majority focus on CDS contracts written on corporate bonds1, and their data do not cover the past several years, in which the CDS market grew rapidly and then went through the financial crisis. Of the few papers devoted to the study of sovereign CDS spreads, most focus on emerging markets. We know of only two papers on sovereign credit risk in the European Union based on CDS market data.2 The size of the markets, the intrinsic interest of the recent period, and the policy relevance of CDS market performance would seem to justify our further work using a different approach.
1 Hull et al (2004) and Blanco et al (2005).
2 Arce et al (2011) and Fontana and Scheicher (2010).
Our sample period runs from 30 January 2004 through 11 March 2011. The time span covered by the regression analysis is equal for each country, at the price of using fewer observations. We restricted our analysis to six countries for which daily estimates of five-year government bond yields are available on DataStream market curve analysis, to make sure that market data are reasonably comparable. Stored government bond yield curves were available for nine EU countries. Among those, CDS quotes for Spain were available for only 1,556 days, instead of 1,879 as for the rest of the sample. Therefore, Spain has been excluded from the analysis. The countries in our resulting sample are Austria, Belgium, Greece, Ireland, Italy, and Portugal.
Our empirical analysis confirms that that the two prices are equal to each other in long-run equilibrium, as theory predicts. One interpretation is that the derivative market correctly prices credit risk: sovereign CDS contracts written on Eurozone borrowers seem to be able to provide new up-to-date information to the sovereign cash market during the period 2004–11. We find, however, that in the short run the cash and synthetic markets price credit risk differently to various degrees. Note also that even if the CDS market prices credit risk ‘correctly’ in the long run, that does not mean that credit risk as priced by either the CDS or the cash market reflects ‘fundamentals’.
In general, our results show that the derivative market seems to move ahead of the bond market in price discovery. This goes in line with the results of Zhu (2006), but contrasts with Ammer and Cai (2011), suggesting that the dynamics for developing and developed economies may be very different as far as sovereign credit risk is concerned.
According to our findings, Eurozone sovereign risk seems to behave closer to developed countries’ corporate credit risk than to developing economies’ sovereign risk.
A second aspect of our empirical work provides information about the dynamics of adjustment to the long-term equilibrium between sovereign CDS and bond yield spreads. Deviations from the estimated long-run equilibrium persist longer than if market participants in one market could immediately observe the price in the other, consistent with the hypothesis of imperfections in the arbitrage relationship between
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the two markets. Probably due to its liquid nature, the Eurozone CDS market seems to move ahead of the corresponding bond market in price adjustment, both before and during the crisis.
There is an alternative causal interpretation of our results. The CDS market may lead in price discovery because changes in CDS prices affect the fundamentals driving the prices of the underlying bonds. If the CDS spread affects the cost of funding of the sovereign (or corporate), then a rise in the spread will not merely signal but will cause a deterioration in credit quality, hence a fall in the bond price (see Bilal and Singh 2012).
Such a mechanism could be destabilising; we discuss this further below. Moreover, speculative use of CDS may ‘divert capital away from potential borrowers and channel it into collateral to support speculative positions. The resulting shift in the cost of debt can result in an increased likelihood of default and the amplification of rollover risk’
(Che and Sethi 2011).
Indeed, the change in spread may not signal at all: various non-fundamental determinants can affect the spreads (as in Tang and Yan 2010) and therefore the fundamentals of the reference entity. To confront this hypothesis with the data will require a dynamic model admitting multiple equilibria. Research along these lines is just beginning (eg, Fostel and Geanakoplos 2012).
We now turn to naked CDSs. The CDS market began in the late 1990s as a pure insurance market that permitted bondholders to hedge their credit exposure – an excellent innovation. But then market participants realised that they could buy and sell ‘protection’ even if the buyer did not hold the underlying bond. This is a naked CDS, which offers a way to speculate on the financial health of an issuing corporate or sovereign without risking capital, as short-selling would do. That was so attractive that soon the market was dominated by naked CDSs, with a volume an order of magnitude greater than the stock of underlying bonds.
Like almost all the financial innovations in recent years, naked CDSs are said to be a beneficial move towards more complete markets. And speculation, we are told, is
essential to the proper functioning of markets. This is simply market fundamentalism that ignores masses of research on destabilising speculation as well as a key lesson of the financial crisis, that some innovations have been dysfunctional and dangerous.
A much more serious justification of naked CDSs is that the overall CDS market, of which these are the dominant component, improves pricing efficiency. The CDS market leads the cash bond market in price discovery and in predicting credit events. Our empirical results appear to bear this out, at least for sovereign bonds in several countries of the Eurozone. Smart traders in the market reveal information, and the CDS market can provide information when the bond markets are illiquid. Still, ‘leadership’ may be the result not of better information, but of the effect of CDS prices on the perceived creditworthiness of the issuer. We return to this key issue below.
CDS prices have many defects as information. They are often demonstrably unrelated to default probabilities – as when the German or UK sovereign CDS price rises; or when corporate prices are less than those for the country of residence, even though the corporate bond yield is much higher than that on the country’s government bond. Many highly variable factors influence the CDS-bond spread: liquidity premia, compensation for volatility, accumulating counterparty risk in chains of CDS contracts. What do pricing efficiency and the informational content of prices mean in a highly opaque market, where much of the information is available only to a few dealers?
Some argue that because net CDS exposures are only a few percent of the stock of outstanding government bonds, ‘the tail can’t wag the dog’, so the CDS market can’t be responsible for the rising spreads on the bonds. This of course contradicts the argument that the CDS market leads in price discovery because of its superior liquidity. More important, it is nonsense. Over a period of several days in September 1992, George Soros bet around $10 billion against sterling, and most observers believe that this significantly affected the market – and the outcome. But daily foreign exchange trading in sterling then before serious speculation began was somewhat over $100 billion. The Soros trades were small relative to the market, yet they had a huge impact, just as the
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CDS market can move the market for the underlying now. The issue is how CDS prices affect market sentiment – in particular, whether they serve as a coordinating device for speculation. We return to this below.
Perhaps the weakest argument is that banning naked CDSs “would also confine hedging to a world of barter, requiring one to find those with opposite hedging needs” (Financial Times 2010). If the insurer doesn’t want to take on the risk, it shouldn’t be selling insurance.
Some say that naked CDSs are justified because they add liquidity to the market. But is the extra liquidity worth the costs? And we now turn to these.
The most obvious argument against naked CDSs is the moral hazard arising when it is possible to insure without an ‘insurable interest’ – as in taking out life insurance on someone else’s life (unless she is a key executive in your firm, say).
The most important concern is related to this moral hazard. Naked CDSs, as a speculative instrument, may be a key link in a vicious chain. Buy a CDS low, push down the underlying (eg, short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that will not cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations (see Cohen and Portes, 2006).
The mechanism of CDSs is like that of reinsurance. The fees are received up front, the risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will
then hedge its position by buying CDSs. So the net is much less than the gross, but the chain is based on the view that each party can and will make good on its contract. If there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause a drying-up of liquidity. The long chains may create large and obscure concentration risks as well as volatility, since uncertainty about any firm echoes through the system.
Naked CDSs increase leverage to the default of the reference entity. They can thereby substantially increase the losses that come from defaults. And the leverage comes at low cost – nothing equivalent to capital requirements, no reserve requirement of the kind insurers must satisfy.
What are the policy implications? We do find that for Eurozone sovereign debt, the CDS and cash market prices are normally equal to each other in long-run equilibrium, as theory predicts. One interpretation is that the derivative market prices credit risk correctly: sovereign CDS contracts written on Eurozone borrowers seem to be able to provide new up to date information to the sovereign cash market during the period 2004–11. In the short run, however, the cash and synthetic markets price credit risk differently to various degrees. Second, the Eurozone CDS market seems to move ahead of the corresponding bond market in price adjustment, both before and during the crisis.
CDS contracts written on Eurozone borrowers seem to be able to provide new up to date information to the sovereign cash market during the period 2004–11. And CDS contracts clearly do play a useful hedging role. None of this, however, justifies naked CDSs, which appear to play a destabilising role both in theory and in various episodes of the financial crisis.
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References
Ammer J and F Cai (2011), “Sovereign CDS and Bond Pricing Dynamics in Emerging Markets: Does the Cheapest-to- Deliver Option Matter?”, Journal of International Financial Markets, Institutions and Money, 21(3):369–87.
Arce O, S Mayordomo, and J I Pena (2011), “Do sovereign CDS and Bond Markets Share the Same Information to Price Credit Risk? An Empirical Application to the European Monetary Union Case”, Federal Reserve Bank of Atlanta Working Paper.
Bilal, M and M Singh (2012), “CDS Spreads in European Periphery - Some Technical Issues to Consider”, IMF Working Paper WP/12/77.
Blanco R, S Brennan, and I W Marsh (2005), “An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps”, Journal of Finance 60(5): 2255–81.
Che, Y-K and R Sethi (2011), “Credit derivatives and the cost of capital”, mimeo, Columbia University.
Cohen, D and R Portes (2006), “A lender of first resort”, IMF Working Paper P/06/66.
Duffie, D (1999), “Credit Swap Valuation”, Financial Analysts Journal 55(1): 73–87.
Financial Times (2010), “Europe’s sovereign credit default flop”, editorial, 10 March.
Fontana A and M Scheicher (2010), “An Analysis of Eurozone Sovereign CDS and Their Relation with Government Bonds” ECB Working Paper Series No. 1271.
Fostel A and J Geanakoplos (2012), “Tranching, CDS and Asset Prices: How Financial Innovation can Cause Bubbles and Crashes”, American Economic Journal:
Macroeconomics 4(1): 190–225.
Hull J, M Predescu, and A White (2004), “The Relationship Between Credit Default Swap Spreads, Bond Yields, and Credit Rating Announcements”, Journal of Banking and Finance 28(11): 2789–2811.
Tang D and H Yan (2010), “Does the Tail Wag the Dog? The Price Impact of CDS Trading”, mimeo.
Zhu H (2006), “An Empirical Comparison of Credit Spreads between the Bond Market and the Credit Default Swap Market”, Journal of Financial Services Research 29 (3):
211–35.
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About the author
Richard Portes, Professor of Economics at London Business School, is Founder and President of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes at the Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairman of the Board of Economic Policy. He is a Fellow of the Econometric Society and of the British Academy. He is a member of the Group of Economic Policy Advisers to the President of the European Commission, of the Steering Committee of the Euro50 Group, and of the Bellagio Group on the International Economy. Professor Portes was a Rhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton, Harvard, and Birkbeck College (University of London). He has been Distinguished Global Visiting Professor at the Haas Business School, University of California, Berkeley, and Joel Stern Visiting Professor of International Finance at Columbia Business School. His current research interests include international macroeconomics, international finance, European bond markets and European integration. He has written extensively on globalisation, sovereign borrowing and debt, European monetary issues, European financial markets, international capital flows, centrally planned economies and transition, macroeconomic disequilibrium, and European integration.
The worldwide financial crisis that erupted in 2007 has revealed the fragility of major financial institutions, and triggered the sharpest global recession since the 1930s. Before the crisis, standard macro theory largely abstracted from financial intermediaries, and macro forecasting models ignored information on bank balance sheets. The dramatic events since 2007 require a rethinking of the role of global finance for real activity, and will represent a challenge for economic research for years to come. Several of my PEGGED research projects have addressed this challenge, by presenting novel theoretical and empirical analyses of the role of global banks for business cycles in the EU and in the world economy. These contributions also highlight the stabilising role of government support to banks, during a financial crisis.
A tractable framework for analysing the interaction between banks and the real economy
A tractable framework for analysing the interaction between banks and the real economy