Euro Zone Sovereign Debt Crisis: Empirical Study on the Dynamics of Credit Default Swaps and Bond Prices

Abstract

During the euro zone debt crisis demand for credit default swaps (CDS) has increased substantially. This thesis studies in which of the markets – derivative or underlying – the credit risk price discovery occurs, with a vector error correction model. Before it can be deployed an augmented Dickey-Fuller test is performed to confirm that the CDSs and bond yields are integrated of the same order. Then Johansen cointegration test is conducted to see if the series are cointegrated. After this, speed-of-adjustment coefficients are calculated to see which of the markets dominates the credit risk price discovery process with the help of Gonzalo and Granger measure.

The data for this thesis consists of 5-year CDS premiums and underlying bond yield spreads of twelve different euro area countries. In the calculation of the bond spread, this thesis evaluates the suitability of German government bond yield and Euribor swap rate functioning as a proxy for the proper risk-free rate. Evaluation is done in the form of basis analysis. The time period of the sample is divided into two separate sub-samples for the purpose of studying the price discovery process in different regimes. The first period (pre-crisis) spans from January 1, 2007 to September 30, 2009 and the second period (crisis) from October 1, 2009 to November 25, 2011.

During the pre-crisis period bond yields were leading the credit risk price discovery process in case of Finland and Italy, and CDSs where leading the process in case of Portugal. During the crisis period this relation changed in favour of bond yields as they gained the leadership position in eight different countries and the opposite was observed only for Finland. Furthermore, findings from the basis analysis suggest that instead of Euribor swap rate, German government yield should be used as a proxy for the risk-free rate for the euro area sovereigns.