Price discovery in euro area sovereign credit markets. Evidence from the GIIPS countries, ten years after the implementation of the ban on naked CDS trading.
Following a period of excessive liquidity and low sovereign risk in the euro area, changing economic conditions require banks with high amounts of domestic sovereign debt and financial market participants to carefully understand the price discovery dynamics in CDS and bond credit markets.
Sascha Häusler, 2023
Bachelor Thesis, FHNW Institute for Finance
Betreuende Dozierende: Kristyna Ters
Keywords: Sovereign credit risk, Sovereign CDS, Credit default swaps, Price discovery
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Subsequent to the financial crisis of 2008, EU policymakers raised concerns that destabilising speculation via outright short-selling of sovereign CDS contracts was among the root causes of excessively high credit spreads in the most distressed EU member states. Therefore, they introduced a ban on naked CDS trading in 2012. Ten years after its implementation and in the presence of rising interest rates and increased banks' exposure to sovereign risk, the analysis of price discovery in the euro area sovereign credit markets requires an update to understand the current dynamics in those markets.
To research the credit risk price discovery process in euro area credit markets, a systematic empirical analysis was applied to the CDS and bond markets of the sample countries. First, the no-arbitrage theory was investigated for each country. In the next step, the analysis emphasised the price discovery process and the relative contribution of each market towards price discovery by applying a VECM approach and Gonzalo Granger's measure. In addition, the results were placed in the context of the economic conditions of the observed period to provide a holistic understanding.
The study provides updated insights into the dynamics within the euro area sovereign debt markets. The empirical analysis revealed that the CDS-bond basis was typically different than zero, thus deviating from the no-arbitrage theory. However, frictions and market imperfections make such arbitrage trades difficult. The main finding of this study was a shift from a CDS leadership to a bond price leadership for most sovereign credit markets, compared to findings by previous research on shorter post-ban periods. This finding implies that new information is incorporated quicker in bond prices, and CDS prices tend to adjust. Additionally, the study found a decline in the enormously widened CDS-bond basis after the implementation of the ban in 2012, but also that it cannot be attributed solely to the regulation itself. Finally, further investigation revealed that those unconventional measures undertaken by the European Central Bank (ECB), such as the quantitative easing programme (QE) flooding the sovereign bond markets with liquidity, influenced the credit market functionality and altered it entirely in Italy.
Studiengang: Business Administration International Management (Bachelor)
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