Sovereign CDS and bond credit spread dynamics in the Euro zone: evidence of an asymmetric price transmission in sovereign debt markets

In this paper, I address the price discovery process in the Euro zone sovereign credit risk markets. In particular, I analyse the dynamics between CDS spreads and bond credits spreads, which are regarded by market participants as close substitutes. Indeed, by no-arbitrage conditions there should be a close relationship between them. Recent empirical research shows that short-term deviations between the variables may arise due to market frictions, yet they disappear in the long-term. This error-correction mechanism translates into a cointegration relationship between the spreads. In contrast with recent literature and as a novelty, I show that the speed of adjustment of the error-correction mechanism may depend on the size and the sign of the departure from the long-term equilibrium relationship between credit spreads and CDS spreads. One of the implications of these findings is that deviations may even subsist in the long-run if they do not achieve a certain threshold. This asymmetric cointegration also affects the contribution of each market to price discovery. Indeed, it seems that the contribution of each market to price discovery is significantly affected by the sign and size of the deviations. In some cases, one observes a change of the leading market in terms of price discovery with the regime change.