TY - JOUR

T1 - Short-term determinants of the idiosyncratic sovereign risk premium: A regime-dependent analysis for European credit default swaps

AU - Calice, G

AU - Mio, RH

AU - Sterba, F

AU - Vasícek, B

PY - 2015/9

Y1 - 2015/9

N2 - This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markovswitching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this 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, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility. (C) 2015 Elsevier B.V. All rights reserved.

AB - This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markovswitching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this 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, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility. (C) 2015 Elsevier B.V. All rights reserved.

U2 - 10.1016/j.jempfin.2015.03.018

DO - 10.1016/j.jempfin.2015.03.018

M3 - Article

VL - 33

SP - 174

EP - 189

JO - Journal of Empirical Finance

JF - Journal of Empirical Finance

SN - 0927-5398

ER -