An analysis of euro area sovereign CDS and their relation with government bonds

Alessandro Fontana and Martin Scheicher

Journal of Banking & Finance, 2016, vol. 62, issue C, 126-140

Abstract: We compare the market pricing of euro area government bonds and the corresponding Credit Default Swaps (CDSs). In particular, we analyse the “basis” defined as the difference between the premium on the CDS and the credit spread on the underlying bond. Our sample of weekly data covers the period from January 2007 to December 2012 and contains several episodes of sovereign market distress. Overall, we observe a complex relationship between the derivatives market and the underlying cash market characterised by sizable deviations from the no-arbitrage relationship (i.e. basis equal to zero). We show that short-selling frictions explain the persistence of positive basis deviations while funding frictions explain the persistence of negative basis deviations which are observed for countries with weak public finances. Moreover, we show that the “flight-to-quality/liquidity” phenomenon in bond markets is a key driver of the large positive basis of better rated countries.

Keywords: CDS; Government bond; Short-selling frictions; Funding liquidity; Financial crisis; Arbitrage (search for similar items in EconPapers)
JEL-codes: G00 G01 G1 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (105)

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Working Paper: An analysis of euro area sovereign CDS and their relation with government bonds (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:62:y:2016:i:c:p:126-140

DOI: 10.1016/j.jbankfin.2015.10.010

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