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Short-Term Determinants of the Idiosyncratic Sovereign Risk Premium: A Regime-Dependent Analysis for European Credit Default Swaps

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  • Giovanni Calice
  • RongHui Miao
  • Filip Sterba
  • Borek Vasicek

Abstract

This study investigates the dynamic behavior of the sovereign CDS term premium for a group of European countries. The CDS term premium can be regarded as a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets in real time. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium into two unobserved components of statistically different nature (stationary and nonstationary) and study the determinants of their short-term dynamics. Specifically, we link these components in a vector autoregression to various daily observed financial market variables. We find that decomposition into the two components is vital for understanding the short-term dynamics of the entire CDS term premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, our results suggest that the response of the CDS term premium to shocks to financial variables is regime-dependent and can be ten times stronger during periods of high volatility.

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  • Giovanni Calice & RongHui Miao & Filip Sterba & Borek Vasicek, 2013. "Short-Term Determinants of the Idiosyncratic Sovereign Risk Premium: A Regime-Dependent Analysis for European Credit Default Swaps," Working Papers 2013/13, Czech National Bank.
    • Handle: RePEc:cnb:wpaper:2013/13
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    1. Mustafa Akay & Berat Bayram & Abdullah Kazdal & Muhammed Hasan Yilmaz, 2020. "Investigating Regime-Dependent Dynamics in Country Risk Premium: Evidence from Turkey and Emerging Markets," CBT Research Notes in Economics 2008, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.
    2. Giovanni Calice & Ming Zeng, 2021. "The term structure of sovereign credit default swap and the cross‐section of exchange rate predictability," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 26(1), pages 445-458, January.
    3. Buse, Rebekka & Schienle, Melanie, 2019. "Measuring connectedness of euro area sovereign risk," International Journal of Forecasting, Elsevier, vol. 35(1), pages 25-44.
    4. Di Tommaso, Caterina & Foglia, Matteo & Pacelli, Vincenzo, 2023. "The impact and the contagion effect of natural disasters on sovereign credit risk. An empirical investigation," International Review of Financial Analysis, Elsevier, vol. 87(C).
    5. Mili, Mehdi, 2019. "The impact of tradeoff between risk and return on mean reversion in sovereign CDS markets," Research in International Business and Finance, Elsevier, vol. 48(C), pages 187-200.
    6. repec:cnb:ocpubv:rb13/1 is not listed on IDEAS
    7. repec:cnb:ocpubv:rb13/2 is not listed on IDEAS
    8. Gurudeo Anand Tularam & Rajibur Reza, 2016. "Water exchange traded funds: A study on idiosyncratic risk using Markov switching analysis," Cogent Economics & Finance, Taylor & Francis Journals, vol. 4(1), pages 1139437-113, December.
    9. Agata Kliber, 2016. "The leverage effect puzzle: the case of European sovereign credit default swap market," Review of Derivatives Research, Springer, vol. 19(3), pages 217-235, October.
    10. repec:cnb:ocpubv:rb14/1 is not listed on IDEAS
    11. Kutuk, Yasin & Barokas, Lina, 2022. "Multivariate CDS risk premium prediction with SOTA RNNs on MI[N]T countries," Finance Research Letters, Elsevier, vol. 45(C).
    12. Yuting Gong & Zhongzhi He & Wenjun Xue, 2023. "EPU spillovers and sovereign CDS spreads: A cross‐country study," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(12), pages 1770-1806, December.
    13. Fredy Gamboa-Estrada & José Vicente Romero, 2022. "Modelling CDS Volatility at Different Tenures: An Application for Latin-American Countries," Borradores de Economia 1199, Banco de la Republica de Colombia.
    14. repec:cnb:ocpubv:rb14/2 is not listed on IDEAS
    15. Polat, Tandogan, 2016. "Essays on banking sector’s dynamics, expectations, preferences and impact," Other publications TiSEM d064f029-f91e-47bc-b6d3-0, Tilburg University, School of Economics and Management.
    16. Sara Cecchetti, 2020. "An analysis of sovereign credit risk premia in the euro area: are they explained by local or global factors?," Temi di discussione (Economic working papers) 1271, Bank of Italy, Economic Research and International Relations Area.

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    More about this item

    Keywords

    Credit default swaps; Markov switching model; sovereign risk; State space model; term premium.;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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