Why Do Investors Buy Sovereign Default Insurance?

We provide empirical evidence of a significant complementarity between the size of a country’s debt and the net amount of insurance purchased against default by its government, based on a novel data set of net notional amounts outstanding for single-name sovereign credit default swaps (CDS) from October 2008 to September 2015. Domestic and international debt, the underlying reference obligation for many CDS contracts, reflect different information sets and, together with the size of the economy, explain up to 75% of the cross-country variation in net insured positions. Unlike for CDS spreads, for which a single principal component accounts for 54 percent of the cross-sectional variation, common global factors explain only up to 7 percent of the variation in sovereign CDS net notional amounts outstanding, consistent with findings that net sovereign insurance is driven primarily by country-specific risk. We further pinpoint two economic channels that explain the net trading in sovereign CDS: (a) country-specific credit risk shocks that change banks’ capital requirements based on regulatory rating thresholds, and (b) the issuance, but
not the announcement, of domestic and international debt. All our findings suggest a strong hedging motive for the use of sovereign CDS.