Determinants and Price Discovery of China Sovereign Credit Default Swaps

Transcription

1 Deerminans and Price Discovery of China Sovereign Credi Defaul Swaps Thomas Eyssell College of Business Adminisraion Universiy of Missouri-S. Louis One Universiy Blvd S. Louis, MO Tel: ; Fax: (314) Hung-Gay Fung College of Business Adminisraion & Cener of Inernaional Sudies Universiy of Missouri-S. Louis One Universiy Blvd S. Louis, MO Tel: (314) ; Fax: (314) Gaiyan Zhang College of Business Adminisraion Universiy of Missouri-S. Louis One Universiy Blvd S. Louis, MO Tel: (314) ; Fax: (314)

2 Deerminans and Price Discovery of China Sovereign Credi Defaul Swaps Absrac We sudy he deerminans of levels and changes of sovereign credi defaul swap (CDS) spreads in China from January 2001 o December Boh counry-specific facors (such as he China sock marke index and he real ineres rae) and global facors (he U.S. S&P 500 sock opion volailiies and defaul spreads, and he non-norh America global sock marke facor) have significan explanaory power on CDS spreads in erms of boh level and in changes. China s domesic economic facors were more relevan in explaining he CDS spread levels and changes in he earlier years, while he impac of global facors has become increasingly imporan in recen years, paricularly during he global crisis. Wihin a vecor auoregressive (VAR) model conrolling for exogenous variables, we find ha China sovereign CDS spread changes lead sock reurns. Keywords: China sovereign credi defaul swaps, deerminans of levels and changes, and lead-lag relaionship. JEL: C12, F36, G15 2

3 Deerminans and Price Discovery of China Sovereign Credi Defaul Swaps 1. Inroducion For he pas hree decades, he Chinese naional economy has demonsraed impressive economic growh, and has now surpassed Japan o become he second larges economy in he world. The subsanial economic growh of China has been aribued in large par o he resuls of marke-oriened economic reforms from a socialis regime sared in lae As China has opened up o he world, i is likely ha is economy has become more closely linked o global economic forces, and he marke prices of is securiies beer indicaors of heir underlying values. We seek o deermine wheher, as a resul, he counry defaul risk can now be priced beer and measured more accuraely han before. One approach o measuring he defaul risk of a counry is by analyzing he pricing of is sovereign credi defaul swap (CDS). The sovereign CDS marke has become imporan in more recen years globally, especially for emerging counries where sovereign risk is an imporan indicaor o foreign invesors in assessing risks of heir foreign direc invesmen and porfolio invesmens. In his paper, we have wo objecives. Firs, we invesigae he deerminans of China sovereign credi defaul swap spreads. Second, we invesigae he price discovery role of China s sovereign CDS on is sock marke movemens. The resuls enable us o beer undersand facors underlying observed CDS behaviors in China and he exen o which he Chinese economy is inegraed wih he world economy. In paricular, we conduc boh level analysis and changes of defaul swap premiums on key variables suggesed by economic heory. 3

4 The credi defaul swap is he simples ype of credi derivaives ha offer proecion agains he credi or defaul risk of bonds or oher ypes of loan arrangemens. The CDS buyer makes periodic paymens o he proecion seller over he life of he swap conrac in exchange for compensaion if defaul or some oher credi even specified in he conrac occurs. In a well-funcioning financial marke, he price of he CDS (i.e., he CDS spread) reflecs he riskiness of he underlying even. As noed by Mengle (2007): Afer incepion, he value of he CDS will depend mosly on changes in credi qualiy as refleced in curren credi spreads. (p. 14) And, wih respec o he proecion offered, several auhors have noed he insurance-like aspec of credi defaul swaps (Gibson 2007; Nelken 1999; and Te 2006). This characerisic of credi defaul swaps is apparen in view of he relaive spreads observed on insrumens associaed wih he so-called BRIC (Brazil, Russia, India and China) counries: Japan s five-year credi defaul swaps-insurance ha bond raders buy agains he risk of defaul-are rading a jus over 100 basis poins, meaning i coss $10,160 a year o insure $1 million of Japanese governmen deb for five years... Insuring he same amoun of Ireland s deb coss $61,600 a year. Bloomberg BusinessWeek March 28-April 3, 2011, p. 15 This new class of asses is designed o rade credi risk on a variey of corporae and sovereign names wih a wide range of mauriies. The CDS was an imporan financial innovaion in he lae 1990s and he credi derivaives marke has experienced phenomenal growh since hen. A he end of 1996 he CDS marke size was only around $40 billion in nominal value. By he end of 2007, he nominal value of all ousanding CDS conracs had reached $62.2 rillion. Afer he financial 4

5 crisis in 2008, he ousanding CDS noional amoun shrank o $31.22 rillion as of mid-2009 due o marke consolidaion. The credi derivaives marke is primarily comprised of wo secors: he corporae secor, accouning for 80% of he marke, and he sovereign secor, accouning for 20% of he marke and mosly composed of credi derivaives on emerging sovereign bonds. 1 The mos acive paricipans in he credi derivaives marke include banks, insurance companies, pension funds, hedge funds and oher asse managers. The increased aenion o hedging emerging marke sovereign risk has fueled he evoluion of he sovereign credi derivaive markes. Similarly, oher derivaives on hedging he Chinese currency are also available. For example, RMB fuures conracs are based on he relaionship beween he U.S. dollar and he Chinese renminbi and are raded a he Chicago Mercanile Exchange (CME) Group in he U.S., while he non-delivery forward conracs are acively raded in he U.S., Hong Kong, and Singapore (Fung, Leung and Zhu 2004). The emerging credi derivaives marke ook off during he second half of In paricular, here is an acive broker marke for China s sovereign CDS. While he debae around he ransparency issue and counerpary risk associaed wih CDS has ye o sele, he number of sudies regarding he valuaion and informaion conen of CDSs coninue o grow. The Meron-ype srucural model links he prices of credi insrumens direcly o he main deerminans of he likelihood and severiy of defaul, including financial leverage, volailiy, and he risk-free ineres rae erm srucure (Meron 1974). Collin-Dufresne, Goldsein, and Marin (2001) find hese variables useful in regressions for changes in 1 The Naional Associaion of Financial Marke Insiuional Invesors backed by he People s Bank of China sared a rial of a new credi-miigaion derivaive produc like a credi defaul swap o help domesic invesors buy and sell insurance agains poenial credi risks in China in Ocober 2010 (Wall Sree Journal, Ocober 29, 2010). 5

6 corporae credi spreads. Ericsson, e al. (2009) find ha leverage, volailiy, and he riskless rae are imporan deerminans of corporae CDS premiums. The explanaory power of he heoreical variables for levels of defaul swap premiums is approximaely 60%. The explanaory power for he differences in he premium is approximaely 23%. Chan-Lau and Kim (2004) explain how Meron s heory of firm can be exended o sovereign counries. In an analogous way, a counry s defaul risk should be inversely relaed o sock prices. If he relaionship beween CDS spreads and sock prices does no hold, capial srucure arbirage should eliminae mispricing. Our benchmark resuls focus on deerminans of China s sovereign CDS spread for he period exending from January, 2001 o December, We examine how domesic facors such as China s sock marke reurns and volailiy, he real ineres rae, he raio of debs o GDP and global facors such as VIX, erm srucure slope, defaul spread and a financial shock dummy variable affec he behavior of CDS spreads. We run regressions on levels in CDS spread as well as for he changes of he spread. We find ha boh counryspecific facors and global facors are imporan deerminans of China s sovereign CDS. In paricular, he China sock marke index, he real ineres rae, he U.S. S&P 500 sock opion volailiies, defaul spreads, non-norh America global sock marke, and he financial crisis dummy have subsanial explanaory power in explaining boh levels and changes of CDS spreads. We furher spli he sample o wo sub-periods. Counry facors appear o be more imporan han global facors o explain he CDS spread levels and changes in he earlier years, while global facors have become increasingly imporan in recen years, paricularly during he global crisis. 6

7 Our second objecive is o examine he exen of price discovery of China sovereign CDS spreads on he sock marke price and he oher way around. Mos sudies on credi defaul swaps focus on corporae CDS and hey reveal ha CDS prices lead sock prices during credi deerioraion episodes a he firm and porfolio levels (Zhang, 2009; Fung, e al., 2008). These CDS are eiher firm specific CDS or are indices ha are compiled from firms. By naure, he sovereign CDS spread is a measure on a counry s aggregae financial healh and is supposed o compensae invesors in his financial insrumen for bearing sovereign defaul risk of a counry. This should be driven by a counry s economic fundamenals. A counry s sock marke has long been viewed as is economic baromeer. A bearish or highly volaile sock marke conveys a negaive message o invesors on he counry s economic fundamenals. Therefore, we expec ha China s CDS marke leads he sock marke. On he oher hand, he sock marke has home advanage and should incorporae more quickly informaion on macroeconomic condiions and micro-level firm fundamenals. The efficien marke hypohesis implies ha he sock marke leads he CDS marke. Our paper is closely relaed o Chan-Lau and Kim (2004), who examine he dynamic relaionship beween emerging marke CDS spreads, bond spreads, and sock prices for eigh emerging markes. Norden and Weber (2009) and Zhu (2006) examine he relaionship beween corporae CDS spreads, bond spreads and sock prices, bu heir focus is on corporae CDS. Fung, e al. (2008) examine he lead-lag relaionship beween he U.S. CDS and sock markes a he porfolio level, and find muual feedback beween he high-yield CDS and sock markes. Chan, Fung, and Zhang (2009) analyze he relaionship of sovereign CDS and sock marke reurns for Asian counries. Hilscher and Nosbusch (2010) examine 7

8 he deerminans of J.P. Morgan s Emerging Marke Bond Index (EMBI) for a se of 31 emerging marke counries from 1994 o 2007 a he annual frequency. They find ha he volailiy of erms of rade in paricular has a saisically and economically significan effec on spreads. Our sudy is in he same spiri of Hilscher and Nosbusch (2010) and exends he analysis by Chan, Fung, and Zhang (2009), and Chan-Lau and Kim (2004), who use sovereign CDS in heir analyses. We examine he feedbacks beween CDS spreads and he sock marke so heir relaionship can be beer undersood. To his end, we use a vecor auoregressive (VAR) sysem conrolling for exogenous variables. We find ha he CDS spread changes leads sock reurns, bu no he oher way around. The leading role of he CDS marke is likely due o fewer resricions, broader invesor base, and greaer informaion advanage in he CDS marke, while he domesic sock marke is relaively inefficien in processing informaion because of marke impedimens. Our sudy conribues o he lieraure in several ways. Firs, we use sovereign China CDS o examine he deerminans of CDS in boh level and changes wih a srucural break. Our sudy is he firs one ha provides his kind of analysis for Chinese research. The resuls show ha he differenial effecs of he underlying variables on he CDS behavior across periods, implying he imporance of srucural breaks. Second, we find he growing imporance of global facors on China s sovereign CDS. In recen periods, he global facors on China s CDS appear o dominae he counry facors, implying ha China s CDS marke is well inegraed wih he global force. Finally, we show ha CDS has predicive power on China s sock marke reurn using he Granger-causaliy es. Addiional analysis using a vecor auoregressive (VAR) model indicaes he CDS has over 2% predicabiliy on China s 8

9 sock marke reurn using variance decomposiion analysis beyond one day. The impulse response analysis shows ha China s sock marke responds o CDS shocks in a day. The remainder of he paper is organized as follows. Secion 2 describes he research issue and Secion 3 discusses he daa. Secion 4 presens he empirical resuls on he fundamenal facors ha are expeced o explain CDS spreads and changes of spreads in regression analysis. We also examine price discovery of he CDS spreads and sock marke prices wihin a VAR framework. The final secion is he conclusion. 2. The Research Issue 2.1 Deerminans of China s Sovereign CDS Spread The corporae CDS allows he ransfer and managemen of credi risks. The purchase of a CDS is equivalen o shoring credi risk on he credi marke (bond/loan marke). Selling a CDS is equivalen o having a long exposure on he credi marke. The marke price of he CDS (i.e., CDS premium/spread) reflecs he risk of he underlying credi. Sovereign CDS provides an ideal plaform o gauge marke views on a counry s defaul risk. According o Meron-ype heory, which akes a balance shee approach o examining he relaionship beween equiy and deb, a firm s liabiliies consiue a barrier poin for he value of is asses. If he value of a firm s asses falls below he face value of is deb, he firm would defaul. Bond and equiy prices are posiively correlaed, and he correlaion is sronger when defaul risk is a major concern. Thus he price relaionship beween CDS spreads and equiy prices should be negaive. The premia on corporae bond (or CDS) spread should be deermined by leverage of he underlying firm, he volailiy of he underlying asses and he riskless spo ineres rae. 9

10 In an analogous manner, he spread of a sovereign CDS should be deermined by he leverage of he counry, he volailiy of counry s asses (as proxied by sock marke volailiy), and he ineres rae. 2 The Meron model predics ha liabiliies as a barrier poin for he value of is asses should be negaively relaed o he bond value. Thus, a counry s deb-o-gdp raio is expeced o be posiively relaed o he sovereign CDS price. The volailiies of underlying asses should be negaively relaed o he bond value. Thus, we expec a posiive relaionship beween he volailiy of a counry s oal asses and he sovereign CDS spread. In addiion o hese wo major facors developed in he Meron s original model, oher counry risk facors could also affec he defaul probabiliies of a counry s exernal deb. In paricular, sock reurns and real ineres rae ne of inflaion reflec he real economic growh or economic srengh. I can be argued ha a bullish sock marke and higher real ineres rae signal sronger compeiiveness of China and hus is defaul risk will be lowered. 3 As CDS pricing reflecs defaul risk and a weaker economy, he real ineres rae is expeced o be negaively relaed o CDS spreads. Due o globalizaion and inerdependence of economies, he inegraion of he China s economy and oher counries has become increasingly sronger. The imporan economic facors in he U.S. and oher counries may also affec China s sovereign risk. Prior sudies (e.g. Hilscher and Nosbusch (2010)) find global facors are imporan deerminans of emerging economies sovereign risk. Pan and Singleon (2008) find ha he VIX is saisically significan in explaining CDS spreads of Mexico, Turkey, and Korea. Therefore, 2 Chan-Lau and Kim (2004) jusified exending he heory from a corporae o a sovereign issuer. 3 Kaplin, e al. (2009) repor a negaive relaionship beween he nominal ineres rae and he defaul rae. In our analysis, we use he real ineres rae, which is a beer measure of reurns o consumers in measuring he relaionship beween ineres rae and defaul. 10

11 we expec ha a more volaile financial markes, greaer defaul risk premium, and lower sock reurns are posiively relaed o he China s CDS spread. Empirically, we use he raio of China s exernal deb o GDP o proxy for he counry s abiliy o repay foreign debs. We use he volailiy of he Shanghai sock marke index reurns as a measure of he volailiy of he counry s asse value. In addiion, we measure counry risk/compeiiveness using he level of Shanghai sock marke index reurns and he real ineres rae calculaed by applying China's 1-year deposi ineres rae and inflaion rae consisen wih he Fisher Effec. To measure he global facors, we include U.S. sock implied volailiy, he U.S. defaul risk premium, he slope of U.S. erm srucure, and he non-norh America financial marke index as addiional explanaory variables for CDS movemens. Generally, i is harder o explain differences in CDS spreads han levels. Thus, a regression in differences should provide a more sringen es of CDS spread deerminans. Following he spiri of Collins-Duffresne, e al. (2001), Ericsson, e al. (2009), and Hilscher and Nosbbusch (2010), we ry o esimae he effecs of differen deerminans for China s CDS spreads. We also use boh counry and global facors as explanaory variables in our regression analysis. 2.2 Equilibrium Relaionships and Price Discovery of he China s Sovereign CDS and Sock Markes The changes in sovereign defaul risk no only affec CDS spreads on he counry, bu hey may also affec he counry s equiy prices. The relaionship beween he sovereign CDS and equiy markes, o a cerain exen, resembles ha beween equiy and bond prices in he 11

12 Meron (1974) framework. Typical firms fiing his bond-equiy price paern are hose wih high deb-o-equiy raios and below invesmen-grade credi raings. In oher words, equiy prices convey useful informaion on sovereign risk when his risk is high (an ou-of-hemoney siuaion faced by counries). Equiy prices are less useful o gauge sovereign risk when he risk is low (an in-he-money siuaion faced by counries), as equiy prices are affeced more by facors oher han defaul risk. In pracice, he link beween he sovereign CDS marke and he sock marke could be o he resul of he capial srucure arbirage, which is one of he mos recen hedge fund sraegies based on Meron s heory. The sraegy explois he pricing inefficiency ha exiss in he capial srucure of he firm. In essence, he capial srucure arbirageur uses a Meronype srucural model o compare he marke CDS spread and he heoreical spread inferred from he model. If he CDS spread is subsanially larger han he prediced spread based on sock prices, an arbirageur can sell credi proecion if he/she believes ha he equiy marke is righ, or sell equiy if he/she believes he CDS spread is righ. In pracice, he arbirageur is probably unsure wheher he equiy marke or he CDS spread is righ. Hence, he arbirageur does boh sraegies of selling credi proecion and shoring equiy. The heoreical relaion beween he CDS spread and he equiy price would prevail in he end, and he equiy posiion can cushion he loss of he CDS posiion, and vice versa (Yu 2006). Similarly, he capial srucure arbirage sraegy can also be applied o he sovereign CDS marke and he sock marke. For example, when a counry has a higher defaul risk, is sock marke performance will be adversely affeced by deerioraing economic fundamenals because a greaer risk premium will be demanded by invesors a home and abroad, or boh. Thus, he price of he counry s sock marke would fall. When a counry is in his siuaion, 12

13 buying insurance agains is defaul becomes more expensive. Therefore, he CDS spread would rise. Also, he demand for proecion agains he counry s poenial defaul increases as credi risk increases. This, in urn, causes furher downward pressure on equiy prices as sellers of credi derivaives proecion hedge heir exposure by eiher shoring bonds, or equiy. Therefore, he sock marke is expeced o be negaively relaed o he sovereign CDS spread. The sovereign CDS marke offers an ideal laboraory o explore he price discovery embedded in defaul swap prices versus oher economic indicaors. Marke praciioners claim ha he CDS marke reacs firs and faser o new informaion on credi risks as compared o oher financial insrumens. Recen empirical sudies appear o validae his claim for corporae issuers in Europe and he Unied Saes. For insance, Blanco, Brennan, and Marsh (2003) analyze a large panel of he U.S. and European corporae issuers and find ha CDS spreads lead bond spreads during credi-deerioraion episodes. Longsaff, Mihal, and Neis (2005) sudy a large sample of corporae issuers in he Unied Saes and found ha he CDS and equiy markes conain disinc informaion. Using he CDX index, Fung, e al. (2008) find ha here exis wo-way ineracions beween he U.S. sock index and he highyield CDX indices. However, he research on he price discovery funcion of he sovereign CDS marke is limied. Zhang (2003) finds ha Argenina s CDS predics credi evens in he counry well before he raing agencies, which had assigned over-generous raings o he Argenine deb, and he raing agencies lagged he credi marke in downgrading he deb. Chan-Lau (2004) find ha here is mixed evidence for emerging marke sovereign CDS. 3. Daa 13

14 The China s sovereign CDS marke has become more liquid over years, as shown by he number of marke dealers. The greaer demand for rading China CDS may reflec ha invesors look o hedge heir exposure o he sovereign and non-sovereign debs, and crosshedge heir exposure o oher Asian emerging counries sovereign and non-sovereign debs as well. We rerieve China s sovereign CDS spreads from a comprehensive daase provided by he Marki Group Limied. 4 The Marki Group collecs corporae and sovereign CDS quoes conribued by more han 30 large banks on a daily basis. A daily CDS spread is a composie quoe only if i has more han hree conribuors. Once a credi defaul swap is priced by Marki, he pricing daa is generally on a coninuous basis. The daa spans he period January, 2001 o December, A daily CDS spread is a composie quoe only if i has more han hree conribuors. Deph is he number of dealer banks ha conribue he quoes of CDS spread o he Marki Group. As he CDS marke is a largely unregulaed over-he-couner marke, no informaion on rading counerparies or rading volume is provided in he daase. The CDS spreads include one-year, wo-year, hree-year, five-year, and en-year CDS spreads. We use only he five-year CDS spreads because hese swap conracs are he mos liquid. To mainain uniformiy in conracs, we only use sovereign CDS quoes for China denominaed in U.S. dollars. We use only he five-year CDS spreads because hese swap conracs are he mos liquid. To mainain uniformiy in conracs, we only use CDS quoes denominaed in U.S. dollars. The China sock marke index is obained from he Shanghai Sock Exchange Composie Index. The real ineres is calculaed from he 1-year deposi ineres rae and he 4 This daase has been widely used for he research on credi defaul swaps. For example, i was used by Jorion and Zhang (2007, 2009), Remolona, e al. (2007), Yu (2006), and Zhu (2006). 14

15 inflaion rae using he Fisher Effec formula. The governmen exernal deb is from he World Bank Global Developmen Finance daa se. GDP daa are from he Inernaional Moneary Fund World Economic Oulook. Reserves refer o he Toal Reserves Including Gold series from he World Developmen Indicaors. In erms of global variables, VIX is he implied volailiy of he US sock marke reurn, which is rerieved from he Chicago Board Opions Exchange. SLOPE is he difference beween he 10-year U.S. Treasury yield and he 3-monh U.S. Treasury bill rae. DEF is he difference beween he yields on Aaa and Baa U.S. corporae bonds. The 10-year U.S. Treasury yield, he 3-monh Treasury bill rae, yields on Aaa and Baa U.S. corporae bonds are from he Federal Reserve Bank of S. Louis. While he US is a major economic uni in he world, Europe and oher emerging markes are playing increasingly imporan pars. Thus, we also include he non-norh America global index reurns calculaed from he Morgan Sanley Capial Inernaional (MSCI) non-norh America global index o proxy for he impacs of counries oher han he U.S. As our daa spans he period of global financial crisis, we also include a dummy variable, SHOCK, which is equal o 1 if he period is afer Sepember 2008, and 0 oherwise. In addiion, we conrol for he liquidiy of he CDS marke using DEPTH, he number of dealers providing he quoes of CDS spread repored in he Marki daabase. Table 1 provides summary saisics on he CDS spread and oher counry and global variables. China marke monhly sock reurns range from -24.6% o 30.3%. The sock marke daily volailiy is relaively low due o he marke resricion of a 10% range for he daily percenage change in eiher way. In erms of he ex pos real ineres rae, which is deermined by boh he 1-year nominal ineres rae and inflaion rae, i ranges from a 15

16 maximum of 4.13% in July, 2009 o -4.23% in February, The average raio of foreign deb o GDP (DEBT_GDP) is 11.74, which is closes o he minimum raio among 32 emerging economies repored in Hilscher and Nosbusch (2010). The raio has a low sandard deviaion of 1.5, ranging from 8.58 o 13.95, suggesing ha China had a very conservaive foreign deb policy. The raio of reserves o GDP has an average of over he sample period. As he correlaion beween Deb/GDP and reserves/gdp is -80.3%, we only use Deb_GDP in our regression analysis o avoid mulicollineariy problem. The mean value is 21.9% for VIX, 2.05% for Slope, 1.16% for DEF and 0.24% for he global marke index. The measure of CDS marke liquidiy, DEPTH, ranges from 2 o 21 banks, indicaing an improvemen of marke liquidiy over ime. [Inser Table 1 here] 4. Empirical Analyses and Resuls In his secion, we es he deerminans of CDS levels and changes as well as is price discovery funcion in China s financial marke. 4.1 Regression on CDS Level To invesigae he deerminans of CDS spread, we firs conduc a regression of CDS spread level and hen changes on a se of counry facors, global facors, and oher conrol variables. The regression for he level analysis is as follows: CDS STK RET 1 _ 2 _ 3 _ 4 _ VIX SLOPE DEF NONNARET SHOCK DEPTH STK 8 VOL REAL 9 INT DEBT 10 GDP (1) Below we discuss predicions of signs on he variables. STK_RET (he Chinese marke sock reurn) is expeced o have a negaive effec on CDS (Fung, e al. 2008). STL_VOL is he sock reurn volailiy calculaed from daily sock reurns for he preceding 21-day window. 16

17 According o he predicion of a Meron-ype model, his volailiy variable would have a posiive effec on CDS. REAL_INT is expeced o affec he CDS posiively because greaer economic growh implies smaller defaul risk. DEBT_GDP (he raio of he governmen foreign debs o GDP) is prediced o have a posiive effec on CDS because a higher foreign deb level should conribue o greaer counry risk. In erms of global variables, we use several proxy variables o represen global forces. VIX is expeced o have a posiive effec on CDS according o Meron-ype model and Pan and Singleon (2008). The ineres rae ha is direcly modeled by a Meron-ype model is he insananeous spo rae, which has been shown o be explained empirically by a erm srucure variable such as SLOPE ha, in urn, is expeced o have a negaive effec on credi spreads (Eichengreen and Mody, 2000 and Ericsson, e. al., 2009). Higher DEF (he difference beween he yields of U.S. BBB and AAA bonds) suggess ha invesors require greaer compensaion for bearing risk, and herefore a higher CDS premium. We also use he sock reurn from a global sock index for non-norh American counries obained from MSCI o proxy for he global forces from counries oher han he US. A financial index is preferred o a real secor model because i reflecs informaion beer and quicker. A negaive sign is expeced beween his variable and he CDS spread. We expec he observed CDS spread o be posiively relaed o SHOCK because he global financial crisis should be associaed wih higher counry risks. A higher value of DEPTH indicaes greaer liquidiy, which is expeced o be negaively associaed wih CDS spreads. Table 2, Panel A, repors resuls from he regressions of end-of-monh and daily levels of China s sovereign CDS spreads on explanaory variables. We group he explanaory variables ino hree caegories: main counry-specific variables, global variables, and conrol 17

18 variables. For he monhly resuls, China sock marke reurns have he expeced negaive sign and are significan, indicaing ha, for periods of high sock reurns, he CDS spread narrows. This finding is consisen wih he findings in Ericsson, e al. (2009) and Collins- Dufresne, e al. (2001) for corporae CDS spreads and corporae bonds, respecively. Consisen wih he prediced signs, REAL_INT and DEBT_GDP are significan explanaory variables. 5 Nex we urn o global facors. VIX is posiive (0.88), which is significan a he 5% level. In addiion, DEF is posiive and significan while he Non-Norh America global marke reurn is negaive and significan. The resuls from hese hree variables suppored our expecaions and are consisen wih Hilscher and Nosbusch (2010) who show ha global facors are imporan. The slope beween 10-year T-bond yield and 3-monh T-bill rae is negaively bu no significanly relaed o CDS spread. The sign is consisen wih he finding of a significan negaive effec repored by Eichengreen and Mody (2000), and Ericsson, e al. (2009). Our measure of high-yield corporae spread, DEF, is significanly posiively relaed o CDS spread, suggesing ha China s CDS spreads are higher when he global risk premium is greaer. We find ha SHOCK is posiively and significanly relaed o he observed CDS spread, as expeced. The adjused R-squared for our regression is 84.59%, which is quie high. [Inser Table 2 here] 5 We use real ineres o proxy for economic growh here and i is also prescribed by Meron s Model. He and Wang (2011) cas doub on he use of real ineres rae for economic growh. Thus, i can be argued he indusrial producion (IP) may be a beer proxy. The correlaion beween our real ineres rae wih IP growh during our sudy period is abou 0.8, which is highly significan. In fac, we also experimen wih IP variable insead of he real ineres rae variable in our regression analysis. The resul shows ha he R-squared wih he real ineres rae is slighly beer han ha using IP and IP is negaive and significan a he daily frequency in he level analysis bu no significan in he change analysis. So, we decided o use he real ineres rae in our sudy and i is also a heoreical variable o be used in he deerminans of CDS. 18

19 For he daily analysis of CDS deerminans, we find all variables (domesic and global variables) are significan a he 1% level and have he correc signs. Overall, he regression of spreads delivers an adjused R-squared of 85.93%, a similar resul as he monhly resuls. In summary, CDS spread is posiively relaed wih he sock marke volailiy, debs o GDP, VIX, DEF, and SHOCK, bu negaively relaed wih he non-norh America global sock marke reurn, real ineres rae, slope of he erm srucure, and marke deph of he CDS. Panel B of Table 2 uses he same variables as in Panel A bu expands he analysis by including he ineracion erms of he shock variable wih sock marke variables. The resuls are larges consisen wih he resuls of Panel A. Of he four ineracion erms, hree variables (i.e., SHOCK wih Chinese sock reurn, real ineres rae and non-norh America global sock reurns) urn ou o be significan. These resuls imply ha he shock variable affecs he CDS behavior significanly and he CDS may be behaving differenly in he laer period han he earlier period. 4.2 Regression on CDS Changes Following Ericsson, e al. (2009), we nex consider he deerminans of CDS spread changes. The regression using he difference in CDS spreads is as follows: CDS _ CHG 1 STK _ RET 2STK _ VOL 3REAL_ INT 4DEBT _ VIX SLOPE DEF NONNARET SHOCK DEPTH GAP (2) where CDS_CHG measures he changes in CDS Oher variables have been defined earlier. Table 3, Panel A, repors he empirical regression resuls. For he monhly analysis, we find ha he only sock reurns and real ineres rae are significan. Tha is, one sandard increase in he sock reurn will have a reducion of 3.50% (i.e., %) in CDS 19

20 spread. Second, he coefficien on REAL_INT is negaive and significan a he 5% level, implying ha one sandard increase in real ineres rae will have a reducion of 4% ( %) in CDS spread. Among he global variables, NONNARET is significan. I is negaively relaed o CDS spread changes. In addiion, DEPTH is negaively relaed o CDS spread changes. The adjused R-squared is 42.79%, which is reasonable for he change analysis, bu lower han ha of he CDS level analysis. For he daily analysis, STK_RET and all four global facors are significan deerminans of CDS spread changes. The adjused R-squared a he daily frequency is only 3.06%, much lower relaive o ha a he monhly frequency. Overall, boh counry and global variables are imporan facors o explain boh level and changes of CDS spread, bu hey are more imporan in explaining CDS spread levels han changes. [Inser Table 3 here] Panel B of Table 3 repors resuls using he same variables as in Panel A and includes ineracion erms of he shock variable wih some financial variables. The ineracion erm changes some of he significance of variables in Panel A. For example, he real ineres is significan in Panel A, bu no longer significan in Panel B. This analysis suggess ha he behavior of he CDS in he shock period differs from he earlier period and hus moivaes us o invesigae he subperiod analysis. 4.3 Relaive Imporance of Counry Facors and Global Facors Over Time Nex, we invesigae he relaive imporance of counry variables and global variables in explaining he levels and changes of China s sovereign CDS spreads in wo sub-period 20

21 analysis. Firs, we look for a srucural break of CDS o divide our sample. In Feb. 2007, Freddie Mac announced ha i would no longer buy he mos risky subprime morgages and morgage-relaed securiies and in March 2007, New Cenury, he larges U.S. independen provider of home loans o people wih poor credi hisories was in defaul of is loans. 6 So, we es srucural breaks using Chow es around his period for poenial informaion leakage using CDS spread levels and changes. We find ha here is a srucural break found in February, 2007 (he F value is and he p value lower han for he CDS levels and he F value is 3.63 and he p value is for he CDS changes). So, we conduc regressions a monhly and daily frequencies for he full sample period, he firs period before February 2007, and he second period afer February Then we conduc he sandard F-es from he regression analysis for he slope differences beween he firs and second periods (Myers and Well, 1995). For he level analysis of he whole period as shown in Panel A of Table 4, he adjused R-squared is 83.3% for he firs period and 84.91% for he second period a he monhly frequency. The real ineres rae is negaive and insignifican in he firs period while i is posiive and significan in he second period, indicaing ha here is a srucural change in he relaionship. In addiion, he deb/gdp was posiive in he firs period and negaive in he second. This is likely due o he massive effors of he Chinese governmen o boos he GDP growh during he crisis period. 7 The F-ess indicae he effecs of hese wo variables on CDS are differen across wo periods. 6 See New Cenury files for Chaper 11 bankrupcy, hp://money.cnn.com/2007/04/02/news/companies/new_cenury_bankrupcy/hp://money.cnn.com/2007/04/02 /news/companies/new_cenury_bankrupcy/. 7 In fac, he deb/gdp raio was reduced o 9.98% in he second period from 12.91% from he firs period. 21

22 The daily analysis reveals boh domesic facors and global facors are highly significan. The R-squared is 83.12% in he firs period and 88.34% in he second period. Again, he F-ess indicae changes in he coefficiens of he many variables beween he wo periods are saisically differen. [Inser Table 4 here] Nex, we examine wheher he similar paerns and dynamics hold for he CDS change analysis. As shown in Panel B of Table 4, he adjused R-squared in he change analysis is 22.36%) in he firs period and 54.03% in he second period. Again, he explanaion power is much lower han he level analysis a he monhly frequency. For he daily analysis, mos of he variables in he second period have a differen effec on he CDS change from he firs period, confirming again he srucural change beween he wo periods. We nex compare he relaive imporance of global facors wih he counry facors more explicily. To his end, we conduc regressions for hree models in he wo subperiods: (1) only he counry variables and he conrol variables are included, (2) only he global variables and he conrol variables are included, and (3) he counry, global and conrol variables are all included. The resuls are repored in Table 4, Panel C. For he whole period, he R-squared is 41.84% in Model 1 and 83.97% in Model 2 a he monhly frequency in he level analysis, indicaing he global facors have a greaer effec on CDS han he counry facor. The resuls are similar in he second period and wih he daily frequency, confirming ha global facor become more imporan over ime. For he change analysis, he R-squared is 17.7% in Model 1 and 34.81% in Model for he whole 22

23 period. This indicaes he global facors are sronger han he counry facor. This paern is similarly obained for he second period and a he daily frequency. The overall resuls in Panel C of Table 4 show ha he global variables are imporan in explaining he level and changes of China s sovereign CDS spreads. Taken ogeher, China s domesic economic facors were more relevan in explaining he CDS spread levels and changes in he earlier years, while he impac of global facors has become increasingly imporan in more recen years, paricularly during he global crisis. This could be driven by he growing inegraion of China s economy ino he world economy. I is also consisen wih he observaion ha he correlaion of financial markes across counries increases as he marke volailiy is greaer during he crisis. 4.4 Price Discovery Analysis and Resuls One of he mos imporan funcions of he financial markes is price discovery, defined by Lehmann (2002) o be he efficien and imely incorporaion of he informaion implici in invesor rading ino marke prices. When closely relaed asses rade in differen markes, i is imporan o invesigae which of he markes conribues mos o he discovery process. Figure 1 demonsraes he relaionship beween China s sovereign CDS spread level and he China sock index. The CDS spread on China declined from over 70 basis poins in 2001 o abou 9 basis poins in January, 2007, reflecing a percepion of lowered sovereign risk and increasing invesor confidence in China. However, in July, 2007 he volailiy of CDS spreads sared o increase, reaching a level of 77 basis poins in March, They proceeded o drif downward for several monhs, bu hen rose dramaically by Ocober, 23

24 2008, reaching heir highes level (180 basis poins) during he enire sudy period. The jump of he CDS spread a he end of 2008 is consisen wih he spread of U.S. financial crisis o a global financial crisis. The Shanghai Sock Exchange Index fell from over 2,100 poins in 2001 o 1,000 poins in 2005, a loss of more han 50%, and only sared o reverse iself in During he same period, he real GDP of China grew, on average, by over 9.3 percen a year. The poor performance of he China sock marke index, in conras wih he rapid growh of he Chinese economy, suggess ha China s sock marke during he early period was an underdeveloped and highly regulaed marke. The sock marke experienced dramaic volailiy during he 2006 and 2008 period. The sock index rose from a level of 1,319 in January, 2006 o a record high of 6,251 in Ocober 2007, hen plummeed o 1,911 in December, The correlaion beween CDS spread changes and he sock marke reurns is - 42% over he whole period, significan a he 1% level. The graph shows ha he CDS prices and sock index levels exhibi an inverse relaionship in he laer period. [Inser Figure 1 here] If he CDS marke and he sock marke price sovereign risk similarly over he long run, heir prices should be coinegraed. The ordinary leas squares (OLS) esimaion mehod would falsely sugges ha he variables are closely conneced by a linear equaion even hough hey are compleely independen of each oher. We es for he exisence of an equilibrium price relaionship or coinegraion using a wo-sep approach. Firs, we examine wheher he price series are characerized by a uni roo using he augmened Dickey-Fuller and Phillips-Perron uni roo ess. The null hypohesis in boh ess is ha he series are 24

25 characerized by uni roos. Tes saisics show ha we canno rejec a uni roo for boh series. However, he hypohesis of a uni roo in he firs differences is rejeced for all series. Johansen s coinegraion rank ess evaluae he null hypohesis of no-coinegraion. This null hypohesis saes ha he coefficien marix has a full rank (equal o 2 for he wo series). If his null hypohesis is rejeced, hen he wo price series are coinegraed and we can affirm ha here exiss an equilibrium price relaionship beween hem. We find ha he Johansen s race saisic is 5.72, which is less han he 10% criical values. So we canno rejec he null hypohesis of no-coinegraion a he 10% level for he sample period. The absence of coinegraion can be aribued o he low deb-o-asse values or he sock marke volailiy, especially during he crisis period. Specifically, when a counry has low deb-oasse values, i is difficul o esimae an equilibrium price relaionship because he correlaion beween CDS spread and equiy prices is also low (- 11.9%). When a counry s sock marke volailiy is high, CDS spreads and equiy prices may be characerized by a nonlinear relaionship ha he coinegraion analysis canno capure. There may be oher explanaions for our resuls. Firs, i may be ha arbirage opporuniies across he CDS and equiy markes canno be exploied because of marke fricions or echnical facors inheren in he Chinese sock marke. Second, sovereign CDS prices no only reflec sovereign risks based on economic condiions, which should be incorporaed in sock prices, bu also reflec a risk premium for aking on sovereign defaul risk, which is differen from he equiy risk premium. Remolona, e al. (2007) find ha he remarkable narrowing of emerging markes CDS spreads beween 2002 and 2006 occurred largely due o a narrowing of he risk premium gaps for speculaive-grade issuers because global invesors have become hungrier for speculaive grade deb. In conras, he falling 25

26 spreads for he invesmen-grade group is largely due o an acual decline in sovereign risk because economic condiions have improved (risk premiums have remained fairly sable). Given ha here are differen marke paricipans in he CDS and sock markes, if he risk premium in he CDS marke differs from ha in he sock marke, i is naural ha here is no long-run equilibrium relaionship beween hese wo markes. Since he hypohesis of a uni roo in he firs difference is rejeced for CDS spreads and sock prices, we use he CDS spread changes and sock reurns as variables in he vecor auoregressive (VAR) sysem in order o invesigae he simulaneous ineracions beween marke sock reurns and CDS index spreads. We conduc he Granger causaliy es o deermine he causal relaionship beween CDS spreads and sock reurns using daily daa, which is appropriae for price discovery analysis in ligh of rapid informaion changes. VAR is an appealing approach o conducing cross-marke analyses beween he CDS marke and oher markes (Chan e al., 2009, Fung, e al., 2008, Blanco e al., 2005, and Longsaff, e al., 2005). To analyze he inerrelaionships beween CDS spreads and sock reurns, we express he VAR model in he following equaions: L L CDS _ CHG c10 1kCDS _ CHG k 2 k STK _ RET k e1 k 1 k 1 (3) L L STK _ RET c 20 1k CDS _ CHG k 2 k STK _ RET k e 2 k 1 k 1 (4) We expand he equaions so ha we can es wheher he coefficiens on STK_RET are joinly equal o 0. If no, we can rejec he null hypohesis ha STK_RET Granger causes CDS_CHG. Oher Granger causaliy for oher equaions are similarly defined. Table 5 summarizes he cross-marke lead-lag relaionship beween he CDS and sock markes a he daily frequency wihin he VAR model conrolling for exogenous 26

27 variables for he whole period and sub-periods. The opimal lag lengh is seven, deermined by he Akaike Informaion Crierion (AIC) and Schwarz Informaion Crierion (SC). When he dependen variable is he CDS spread changes, he resuls for conrol variables are generally consisen wih hose in Table 4, Panel B. 8 Significan variables have he prediced signs. Specifically, VIX and DEPTH are posiively relaed o CDS spread changes. However, we find ha he lagged sock reurn does no have explanaory power for he CDS spread changes. The resuls for he whole period and sub-periods show ha CDS spread changes Granger-cause sock reurns a he convenional level of significance, supporing he leadership role of CDS spreads on he sock reurns. However, here is no evidence ha sock reurns Granger-cause CDS spread changes in any sub-periods. [Inser Table 5 here] The leadership role of he CDS spreads in he price discovery may be explained in wo ways. Firs, he sovereign CDS marke is he new and more innovaive insrumen for rading sovereign risk. Invesors buying sovereign CDS are able o hedge counry risk arising from holdings of sovereign bonds, foreign sock or muual funds. Invesors may also sell CDS o collec insurance premiums from buyers. On he oher hand, speculaors acively rade in he CDS marke o be on movemens of counry risk. The concenraion of liquidiy from differen pools may help make he CDS marke lead he sock marke. Second, paricipans in he CDS marke, which are large inuiional invesors, may have informaion advanage ha will be subsequenly incorporaed ino he sock marke, showing he leadership role of he CDS spreads on he sock reurn. 8 The regression resuls are long because he opimal lag is seven. So i is no repored o save space. 27

28 On he oher hand, he inabiliy of he sock marke reurn o forecas CDS changes is likely due o he speculaive naure of he marke, which is also subjec o heavy governmen regulaions. I has also been long recognized ha he Chinese sock marke does no reflec fundamenal facors of he growing Chinese economy. The insignifican resuls of sock marke reurn on CDS confirm he expecaions ha he Chinese sock marke may no be efficien in processing informaion. To furher examine how well he CDS spread change forecas he sock reurns, we conduc he forecas error variance decomposiion of daily CDS spread change and sock reurns wihin he VAR framework. Table 6 repors percenage of forecas error variance a n-sep-ahead, which is aribuable o earlier shocks (innovaions) from he CDS spread changes and sock reurns (including iself). We lis seps of 1, 5, 10, 15, and 20 days for forecasing purposes. The shock o CDS spread changes explains abou 1.78% of he sock reurn variaion a he 1-day horizon, 2.95% a he 10-day horizon, and 3.02% a he 20-day horizon. The res is explained by is own innovaions. On he oher hand, he shock o sock reurns only explains abou 0.35% of he sock reurn variaion a he 1-day horizon, and up o 0.50% wihin he 20-day horizon. This resul is consisen wih he causaliy analysis in Table 5 ha CDS spread changes can predic sock reurns. [Inser Table 6 here] Figure 2 presens he impulse response funcion of he VAR model. In he sock reurn impulse funcion, we find ha he CDS shock affecs sock reurns largely only a he firs day (he lef diagram on he op panel), afer ha is effec becomes sabilized, indicaing ha he sock marke adjuss o informaion of he CDS marke quickly. A he same ime, he 28

29 sock reurn adjuss is own shock wihin a day or so. However, CDS adjuss o is own shocks somewha slowly. Tha is, i akes abou 3 days (he lef diagram on he lower panel). [Inser Figure 2 here] 5. Conclusions This paper firs examines deerminans of China s sovereign CDS marke using boh counry-specific variables and global variables, and second addresses he dynamic relaionship beween he credi defaul swap spread changes and sock reurns. Our paper conribues o he relaively limied empirical lieraure on emerging marke credi derivaives, which are growing imporance in recen years. Overall, we find ha boh counry and global variables are imporan o explain levels and changes of China s sovereign CDS premium. In assessing he counry-specific facor for sovereign risk, he domesic sock index level serves as a good indicaor of counry risk. In addiion, non-norh America global sock marke reurns, VIX and SLOPE serve as imporan exernal facors. Furhermore, he sub-period analysis suggess ha counry variables are more imporan in explaining he CDS spread levels and changes in he earlier years, while global facors are more imporan han domesic facors in deermining CDS spread levels and changes in more recen years, especially during he recen global crisis. This could be driven by he increasing inegraion of China s economy ino he world economy. In addiion, he correlaion of financial markes across counries generally increases when he marke volailiy is higher. 29

30 When we examine he price discovery issue wihin a VAR framework beween CDS and he sock reurns, we find ha he price discovery akes place primarily in he CDS marke afer conrolling for he exogenous facors. We conjecure ha he price discovery occurs in he CDS marke because of fewer resricions, broader invesor base, and greaer informaion advanage in he CDS marke. In conras, he sock marke in China is relaively shallow and less developed and has regulaory resricions on he daily price movemens. The Chinese sock marke has long been viewed as speculaive in naure and hus is no efficienly reflecing fundamenal value of Chinese economy. However, our impulse response analysis indicaes he Chinese sock reurn adjuss o CDS informaion raher quickly in a day or so. Overall, hese resuls suppor he sovereign CDS as a leading economic indicaor, which provides a basis for cross-marke rading and hedging. I is also useful for economic policy analysis. As China s sovereign CDS marke keeps growing, he deerminans of CDS and he dynamic relaionship beween he credi derivaives marke and he sock marke will evolve gradually. We expec ha he domesic and exernal economic indicaors become more closely linked wih fewer marke resricions, a greaer paricipan base, and a more sandardized derivaives marke. 30