Spillovers of the Credit Default Swap Market

Credit Default Swap (CDS) prices have soared on the edge of a potential sovereign default of some European countries. Interestingly, not only countries on the verge of receiving bailouts have seen their CDS prices rise, but also those from which most of the bailout financing would come, such as Germany. If in fact default probabilities of countries like Germany have risen, should we still view them as safe-havens? In particular, to what extent should we see bond yields rise (as bond prices decline) vis-a-vis CDS spreads? This paper tackles this question by estimating the dynamic responses of bond yields to changes in the CDS spreads. The second, more fundamental question is to assess if the apparent contagion from troubled countries to otherwise-healthy economies is in fact so. I address this question using the Diebold - Yilmaz spillover index methodology for CDS data. I conclude that sovereign debt from Germany, Chile and Japan are unaffected by contagion from other economies and have served as safe-haven assets during the current financial distress episode.