The behavior of emerging market sovereigns' credit default swap premiums and bond yield spreads
Michael Adler and
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Michael Adler: Professor of Finance and Economics, Graduate School of Business, Columbia University, USA, Postal: Professor of Finance and Economics, Graduate School of Business, Columbia University, USA
Jeong Song: Morgan Stanley, USA, Postal: Morgan Stanley, USA
International Journal of Finance & Economics, 2010, vol. 15, issue 1, 31-58
We test whether credit risk for Emerging Market Sovereigns is priced equally in the credit default swap (CDS) and bond markets. The parity relationship between CDS premiums and bond yield spreads (BYS), that was tested and largely confirmed in the literature, is mostly rejected. Prices below par can result in positive basis, i.e. CDS premiums that are greater than BYS and vice versa. To adjust for the non-par price, we construct the BYS implied by the term structure of CDS premiums for various maturities. We are able to restore the parity relation and confirm the equivalence of credit risk pricing in the CDS and bond markets for many countries that have bonds with non-par prices and time varying credit quality. We detect non-parity even after the adjustment mainly in countries in Latin America, where the bases are larger than the bid-ask spreads in the market. We also find that the repo rates of bonds decrease around episodes of credit quality deterioration, which helps the basis remain positive. Copyright © 2009 John Wiley & Sons, Ltd.
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