EDHEC-Risk Institute has performed a theoretical and empirical analysis of the relationship between the price of eurozone sovereign-linked credit default swaps (CDS) and the same sovereign bond markets during the eurozone debt crisis of 2009-2011. The working paper, entitled ‘The Link between Eurozone Sovereign Debt and CDS Prices’, tests the claim that speculative use of CDS by market participants had caused or accelerated the rapid decline in 2010-11 of bond prices in eurozone periphery countries, a claim that led to the decision by the European Parliament and member states on 18 October 2011, to make the ban on so-called ‘naked’ CDS permanent.
The EDHEC-Risk research shows that CDS spreads do not drive the sovereign bond spread in all circumstances, and that in various countries and at various times, the opposite effect is present. The results are in line with those of a recent report from the French regulatory authority, the AMF, entitled ‘Price Formation on the CDS Market: Lessons of the Sovereign Debt Crisis (2010- )’. EDHEC-Risk is keen to stress that certain conclusions in the AMF report should be analysed with care. A causal link between rising CDS spreads and their decision-making character has not been established or proven in the report, which moreover does not include a formal test on the subject.
According to the author of the EDHEC-Risk report, affiliated professor of finance at EDHEC Business School, Dominic O’Kane: “CDS spreads are a cleaner and more transparent measure of market-perceived credit than bonds since CDS are not limited by supply, are as easy to buy as to sell, and have a lower cost of entry. It would be wrong to suggest that the 200bp level highlighted by the AMF report is the level at which the CDS market ’causes’ the bond market spreads to increase. A more valid explanation would be that the CDS market establishes a truer estimate of forward-looking sovereign risk, which is not reflected in the bond market where some market participants are required to hold high-quality eurozone debt.
“The significance of a CDS spread of 200bp is that this corresponds to the approximate capitulation level at which these eurozone bond investors no longer see the sovereign as a ‘safe haven’ due to its deteriorating credit fundamentals and risk of a major downgrade in its credit rating. What we then see is the bond spreads catching up with the ‘fair value’ that had already been established in the CDS market. The CDS and bond markets then begin to move together. Recent events have confirmed this. The widening of Greek CDS spreads before bond spreads in 2010, which was criticized at the time by various governments, was correct and was due to the CDS market being an earlier predictor of default than the bond market,” he said.
EDHEC-Risk considers that by banning ‘naked CDS’ the market is removing one sovereign risk mitigation tool from the toolkit of banks. EDHEC-Risk fears that this can only have the negative and unintended consequence of increasing average sovereign funding costs. The ban will make the market less liquid and will prevent many participants from easily hedging the sovereign risk that they wish to avoid. These participants include investors in infrastructure projects as part of public-private partnerships, equity investors who wish to avoid the sovereign risk included in certain stocks, banks who wish to hedge the sovereign risk of their commercial loans, and trading desks buying protection in order to hedge their credit value adjustment (CVA) risk.
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