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The price discovery process in credit derivative market: evidence from sovereign CDS market

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  • Nan Li

Abstract

The US subprime loan crisis in 2007 has caused astonishing domestic and international financial turmoil, both directly and indirectly. Being a main factor in facilitating mortgage securitisation, credit derivative market is now under the blame of underestimating credit risk and aggregating the impact of credit risk. It is worthy of revisiting the contribution of credit derivative products to their underlying bond markets in discovering the true level of credit risk. In this paper, I use sampled credit default swap (CDS) contracts written on sovereign borrowers, to investigate the pricing relationship between sovereign CDS and bond markets. My purpose is to find whether the newly innovated derivative market can help bond market to reveal more pricing information on credit risk, or just add more noise to it. Applying vector error correction model (VECM) to a data sample ranging from 1999 to 2002, I find no statistical evidences with regard to the pricing contribution of sovereign CDS market. Instead, sovereign bond market advances in price discovery process by at least one week. Moreover, there exists a significant price gap between the two measures of credit risk: CDS rate and the yield spread of its underlying bond. This further reduces the effectiveness of using sovereign CDS in credit risk hedge.

Suggested Citation

  • Nan Li, 2009. "The price discovery process in credit derivative market: evidence from sovereign CDS market," American Journal of Finance and Accounting, Inderscience Enterprises Ltd, vol. 1(4), pages 393-407.
    • Handle: RePEc:ids:amerfa:v:1:y:2009:i:4:p:393-407
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    Cited by:

    1. Evgenia Grigoryeva, 2021. "Determinants of Russia's Sovereign Risk," Russian Journal of Money and Finance, Bank of Russia, vol. 80(4), pages 74-97, December.
    2. Patrick Augustin, 2012. "Sovereign Credit Default Swap Premia," Working Papers 12-10, New York University, Leonard N. Stern School of Business, Department of Economics.
    3. Wang, Alan T. & Yang, Sheng-Yung & Yang, Nien-Tzu, 2013. "Information transmission between sovereign debt CDS and other financial factors – The case of Latin America," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 586-601.
    4. Zubair Ali Raja & William J. Procasky & Renee Oyotode-Adebile, 2020. "The Relative Role of Sovereign CDS and Bond Markets in Efficiently Pricing Emerging Market Sovereign Credit Risk," Journal of Emerging Market Finance, Institute for Financial Management and Research, vol. 19(3), pages 296-325, December.
    5. Sorin Gabriel Anton, 2011. "The Local Determinants Of Emerging Market Sovereign Cds Spreads In The Context Of The Debt Crisis. An Explanatory Study "," Analele Stiintifice ale Universitatii "Alexandru Ioan Cuza" din Iasi - Stiinte Economice (1954-2015), Alexandru Ioan Cuza University, Faculty of Economics and Business Administration, vol. 58, pages 41-52, november.

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