An analysis of Eurozone sovereign credit default swaps: An empirical investigation of the determinants of the spread on sovereign credit default swaps from 2003-2012

Mari Kolstad

Student thesis: Master thesis


The thesis investigates the determinants of sovereign credit default swaps (CDS) from the period March 2003 and until January 2012. Following the European sovereign debt crisis, credit risk for a number of European countries increased enormously. The paper investigates the proposed pricing changes of sovereign risk by analysing the spread on CDS for seven Eurozone countries: France, Germany, Ireland, Italy, Portugal and Spain. The study sheds light on the mechanisms of sovereign CDS pricing. A set of compressive econometrics techniques is carried out to create the analysis. A Principal Component Analysis (PCA) is employed to investigate the commonalities in the CDS spread where the regression analysis finds there to be one main driver of sovereign credit risk, but less co-movement between the various CDS spreads are found during the debt crisis compared to the period prior to the crisis. The paper develops an empirical model based on a set of country-specific and global risk determinants. The model tries to explain CDS spreads and determine whether the market pricing of risk differ for the indebted countries compared to more stable euro-zone countries. An analysis of the period prior to the crisis is compared to an analysis carried out of the time during the sovereign debt crisis. The model finds significant effects from global variables, local stock markets and countries’ credit ratings in addition contagion effects are detected. Country specific variables, such as government debt levels and fiscal balances, lack explanatory power and does not contribute significantly to the pricing of sovereign risk. Significant pricing differences are found for the various countries and prior to the debt crisis compared to during the crisis. The model does not explain the pricing of CDS to a satisfactory level for Greece, Portugal and Spain prior to the crisis, while the model has increased explanatory power during the sovereign debt crisis for the indebted countries. Sovereign risk in the stable economic, France and Germany, is explained by different determinants that the indebted countries. The same empirical model is tested on the underlying bond yield spread, where the model lacks explanatory power. It becomes apparent that sovereign risk is affected by different determinants in the CDS and the bond markets. In addition the thesis investigated the relationships between two widely reckonings indicators of sovereign risk. By employing a cointegration test, the lead-lag relationship between the bond and the CDS market is investigated where a long-run relationship between two markets is detected in several countries. No clear price discovery mechanism is observed. It shows the CDS market leading the bond market in half of the tested sample, while price discovery takes place from the bond market to the derivatives more for the other half. The results show the increased leading role of the CDS market.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2013
Number of pages114