Liquidity Spillovers in Sovereign Bond and CDS Markets. Markets: An Analysis of The Eurozone Sovereign Debt Crisis

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1 Liquidity Spillovers in Sovereign and Markets: An Analysis of The Eurozone Sovereign Debt Crisis Julian Williams - OECD Giovanni Calice School of Management, University of Southampton, England, U.K. Jing Chen School Business and Economics, Swansea University, Wales, U.K. Julian Williams Business School, University of Aberdeen, Scotland, U.K.

2 Eurozone Sovereign Crisis Ongoing issue of liquidity and solvency of various EU governments. Causes are diverse (poor fiscal planning in Portugal, expensive bank guarantees in Ireland, falsified national accounts in Greece) At present Greece, Portugal and Ireland are in receipt of financial guarantees and liquid capital injections via the IMF, EFSF and asset purchases by the ECB. Iceland has also received a substantial bail-out after the collapse of its banking system, earlier on in the crisis. Causes are well known and are for other discussions. This paper looks at the mechanism of transmission of liquidity and information in the price formation mechanism of Eurozone sovereign debt during the period. The paper provides a table of various macroeconomic indicators for 27, 28, 29 and 21 versus the average.

3 Data set Given the controversy surrounding the reporting of various credit spread indices, we have constructed our data set, where possible, from the transaction history. The data set is sourced from Thomson-Reuters Tick History and DataStream. Sovereign bond data is collected using the Super RICs or Reuters Information Codes. The super-rics collect all trades on instruments in the tag range set by the code, i.e. AT5YT=RR literally means pull all yields on traded bonds with a 5 year maturity from the daily collection date. We use the same approach for the market, however aggregation is much more complex. Multiple data vendors provide an array of intra-day and end-of-day information, through Markit and CMA. The data set is then hand built from these sources and combined into a daily index.

4 Countries in sample We collect all traded sovereign bonds with a maturity of 5 and 1 years for the countries selected in the sample. Originally all Eurozone countries were included in the sample. However, credit default swaps have only been actively traded on ten countries for a long enough period to permit analysis. These countries are Austria, Belgium, France, Germany (the benchmark), Greece, Ireland, Italy, Netherlands, Portugal and Spain. The next slide lists the various sources that CMA and Markit use when building the index of daily spreads.

5 Greek credit spreads Credit Spreads 5 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q Credit Spreads 1 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q4 1

6 Greek liquidity spreads 25 2 Liquidity Spreads 5 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q Liquidity Spreads 1 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q4 1

7 Irish credit Spreads 5 4 Credit Spreads 5 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q Credit Spreads 1 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q4 1

8 Irish liquidity Spreads 8 7 Liquidity Spreads 5 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q Liquidity Spreads 1 Year Q1 7 Q2 7 Q3 7 Q4 7 Q1 8 Q2 8 Q3 8 Q4 8 Q1 9 Q2 9 Q3 9 Q4 9 Q1 1 Q2 1 Q3 1 Q4 1

9 Greek 5 year model first equation β 1,1,t β 1,2,t β 1,3,t β 1,4,t

10 Observations Most important take home messages: Explosive trends present at times in almost all Eurozone countries and in particular Greece, Ireland and Portugal. At this point the market has ceased to function in the normal manner. Without intervention the discount rate would have been driven to infinity. There is a time varying transmission effect from the liquidity spread to the bond market credit spread (violates the nearly complete market condition of Jarrow-Protter 25).

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