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

Giovanni Calice, RongHui Mio, Filip Štěrba and Bořek Vašíček ()

Journal of Empirical Finance, 2015, vol. 33, issue C, 174-189

Abstract: 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 Markov-switching 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.

Keywords: Credit default swaps; Markov switching model; Sovereign risk; State space model; Term premium (search for similar items in EconPapers)
JEL-codes: G01 G15 G21 G24 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

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Related works:
Working Paper: Short-term determinants of the idiosyncratic sovereign risk premium: a regime-dependent analysis for european credit default swaps (2014)
Working Paper: Short-Term Determinants of the Idiosyncratic Sovereign Risk Premium: A Regime-Dependent Analysis for European Credit Default Swaps (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:empfin:v:33:y:2015:i:c:p:174-189

DOI: 10.1016/j.jempfin.2015.03.018

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