Why Do Investors Buy Sovereign Default Insurance?

Patrick Augustin*, Valeri Sokolovski, Marti G. Subrahmanyam, Davide Tomio

*Corresponding author for this work

Research output: Contribution to conferencePaperResearchpeer-review

Abstract

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.
Original languageEnglish
Publication date2018
Number of pages63
Publication statusPublished - 2018
EventThe 78th Annual Meeting of American Finance Association. AFA 2018 - Philadelphia, United States
Duration: 5 Jan 20187 Jan 2018
Conference number: 78
https://editorialexpress.com/conference/AFA2018/program/AFA2018.html

Conference

ConferenceThe 78th Annual Meeting of American Finance Association. AFA 2018
Number78
CountryUnited States
CityPhiladelphia
Period05/01/201807/01/2018
Internet address

Keywords

  • Banking regulation
  • Basel III
  • Credit default swaps
  • Credit risk
  • OTC
  • Systemic risk

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