CREDIT DEFAULT SWAPS AND CREDIT RISK PRICING MELİH SAZAK

Transcription

1 CREDIT DEFAULT SWAPS AND CREDIT RISK PRICING MELİH SAZAK MSc Finance Cass Business School City University London 2012

2 1. Introduction Credit default swap (CDS), a type of over-the-counter derivative, is a bilateral agreement about credit quality of a reference entity. A single-name credit default swap (CDS) is a bilateral contract under which a protection seller promises to make payment on the protection buyer s losses in the event that the entity (i.e., the reference entity) that issued the CDS s underlying bond defaults on its debt obligations prior to maturity of the CDS. In exchange, the buyer promises to make a series of payments (i.e., premiums) to the protection seller. In this sense, CDS is a financial derivative which provides insurance for creditworthiness of any reference entity such as a government or corporate firm. In financial markets, the price of a CDS is quoted in terms of premium which is called spread and CDS spread is accepted to be an indicator of market perception about the credit quality of any single reference entity. Premiums are typically paid on a quarterly or annual basis. Commercial banks buy CDS contracts to hedge their exposure of credit risk of assets (such as corporate bonds) and to benefit from capital relief due to full hedge of credit risk of any single asset in their balance sheet. On the other hand insurance companies, credit derivative product firms and financial guarantors are the sellers of such protection (ECB, 2009). CDS contracts are being used for multiple purposes in financial markets in addition to its main function as a credit derivative to hedge credit risk associated with a specific reference entity. A CDS s reference entity may be a bond issuing corporation or government. They are also widely used by speculators and arbitrageurs to bet on credit quality of any reference entity and their interest in CDS contracts mainly affect both liquidity and spreads in the market (ECB, 2009). CDS contracts may be traded to hedge credit risk associated with a bond issued by a government or corporate firm. Sovereign CDS contracts are being used to hedge debt instruments such as treasury bonds, Eurobonds... etc. issued by sovereign states. Especially after the global financial crisis of 2008, sovereign CDS spreads are primarily monitored to assess and price country risk in international financial markets (Revoltella et al., 2009). Therefore, sovereign CDS spreads which are quoted daily are very significant indicator of country risk and many international investors evaluate sovereign 2

3 CDS spreads before investing in various financial instruments in domestic markets of sovereign state. In addition to this, sovereign CDS contracts are also traded to bet credit quality of sovereign states and speculative use of sovereign CDS leads to increase in borrowing cost of some sovereign states by widening CDS spreads (Briefing on Sovereign CDS, 2011). An investor can also buy a CDS contract without prior purchase of underlying bond issued by a reference entity. In this way, the investor bets on the credit quality of reference entity and expects deterioration of credit quality of reference entity. These CDS contracts are called naked CDS and there is a debate in financial markets about banning these contracts. 2. Theoretical Information on CDS This chapter is mainly about theoretical background on sovereign risk and credit default swaps. Definitions of sovereign risk and credit default swap, information on sovereign CDS market and factors shaping CDS spreads will be discussed in the following sections. 2.1 What is Sovereign Risk? Sovereign risk is defined as credit risk associated with credits granted to sovereign states. It is different from credit risk of an individual firm or a person and it is mainly measured based on macroeconomic variables such as balance of payments flows, foreign currency reserves, economic growth prospects, public budget performance, some political factors etc. The major rating agencies, Standard and Poors, Fitch, Moody s assign sovereign ratings to countries to assess their capability and willingness to repay their debts in accordance with the conditions of specific debt contract within the maturity date. As a result of their assessment, rating firms provide information about possibility of default of a specific country. In this context, default not only means failure to repay interest or principal payments to the creditor, but also means swap or involuntary restructuring of it (Canuto, 2004). 3

4 If a domestic firm becomes insolvent, the lender of the loan would probably attempt to restructure the loan through rescheduling principal and interest payments into the future. In spite of such an attempt, if the firm still is unable to pay its instalments, it would eventually go bankrupt and its assets would be liquidated. This can be an example for credit risk, but sovereign risk is a broader concept. For example; U.S. Financial Institution makes a dollar loan to a private Indonesian corporation and after a while the Indonesian government experiences problems related to its reserve position. Eventually, the Indonesian government prohibits debt payments to be made outside creditors. As a result of this, even though Indonesian firm is solvent and can pay its debt to U.S. Financial Institution, the restriction of the government automatically puts the firm into default. Indonesian government's decision can be defined as sovereign risk or country risk event (Saunders et al. 2008). Sovereign risk is generally thought to be an indicator of risk associated with default probability of debt instruments issued by sovereign states. However, Saunders et. al. (2008) suggest that sovereign risk is a major type of risk which also affects private lending between corporations such as two banks operating in different countries. In other words, it is important to attribute more importance to sovereign risk because it is not only a phenomenon related with purely creditworthiness of a sovereign state, but also significant risk measure affecting private lending activities between nonsovereigns. Due to this, financial market participants attribute great importance to assessing sovereign risk and monitoring the indicators of it such as credit default swap spreads. 2.2 What is Credit Default Swap? David Mengle (2007) head of research at the International Swaps and Derivatives Association (ISDA), defines a credit default swap (CDS) as a contract transferring default risk of one or more entities from one party to another. Protection buyer makes periodic payments to protection seller during the period of CDS protection. If reference entity (government, firms.. etc) defaults, seller will compensate the loss of protection 4

5 buyer due to the default. In such a relation, protection buyer may face with risk of default of reference entity and protection seller (double default) or only the default of protection seller. Moreover, protection buyer may take the risk of maturity mismatch because the maturity of CDS may not precisely match that of the hedged asset. For example; a bank may enter into a CDS with 5 year maturity in order to hedge risk of a 4 year loan because in financial markets 4 year CDS for that reference entity may not exist (Mengle, 2007). Credit event and spread are two major concepts required to be defined in explaining CDS market. Credit event is one of the most important terms in CDS agreements which generally refer to the reference entity s bankruptcy, obligation acceleration, obligation default, failure to pay, repudiation of or moratorium on its debt, or restructuring. Depending on how much interest rate reduction or maturity extension is allowed in CDS contract, the scope of credit event may vary. For example, restructuring of debt may be regarded as credit event if it is stated as credit event in the CDS contract. The size of premium paid by the buyer of CDS is defined in terms of basis point and generally known as CDS spreads. CDS spreads might change depending on demand and supply of a specific CDS contract in the market. CDS spreads resemble to insurance premiums and it reflects market s perception about risk of default or any other credit event associated with reference entity (Flannery, 2010). CDS spreads are quoted in terms of basis points per annum and these spreads are calculated based on nominal value of CDS contracts, but they are usually paid in quarters. For instance, if an investor wants to insure a bond whose nominal value is USD by buying a CDS contract with a spread of 300 basis points, the investor should annually pay USD to the seller. Majority of CDS contracts in the market mature between 2 and 10 years, but 5 year CDS contracts are the most common and liquid type (Revoltella, 2010). 5

6 Upon default, either physical or cash settlement of the CDS will take place. In a physical settlement, the buyer delivers the reference assets to the seller, who makes the protection payoff, which is equal to the reference asset s par value. In a cash settlement, the protection payoff will be equal to the notional amount of the CDS less the market value of the reference assets after default. Commercial banks, hedge funds, insurance firms and financial guarantors are the major players in global CDS markets. In order to improve their investment performance; hedge funds, insurance firms and financial guarantors enter into CDS market by speculating, hedging or making arbitrage using CDS contracts. These institutions are generally on the sell side of CDS market whereas commercial banks are on both buy and sell sides. CDS market enables commercial banks to transfer their credit risk associated with loans to third parties without omitting these loans from their assets (Revoltella, 2010). Actors in the financial markets can take credit risk of a reference entity such as a government or corporation by buying bonds issued by this entity. Selling a CDS contract is also another way of taking the credit risk of a reference entity. However, it is different from investing in bonds because bond investment should be funded, but similar investment, based on credit quality of reference entity made by selling CDS, is unfunded. Because of this, it is possible to conclude that selling a CDS is a cheaper way of taking a credit risk of a reference entity in comparison to investments made in bonds (Report on Sovereign CDS, 2010). An investor can also buy a CDS contract without prior purchase of underlying bond issued by a reference entity. In this way, the investor bets on the credit quality of reference entity and expects deterioration of credit quality of reference entity. As a result of this, investor expects to make profit because value of insurance of any debt instruments issued by a government or company would increase due to weakening of credit quality. This type of CDS is called as naked CDS (Report on Sovereign CDS, 2010). According to Eric Dinallo, who was the New York State Insurance Superintendent, naked CDS constitutes 80 percent of whole CDS market (Bloomberg 6

7 News, 2009). However, since CDS market is an over the counter market (OTC), there is no official data to confirm the volume of naked CDS in financial markets. On the other hand, in a special report on CDS spread and default risk published by Fitch Ratings, it is suggested that CDS spread may not be good indicator for a risk of default. According to this report, CDS spreads may widen because risk managers are willing to overpay for credit protection and liquidity in CDS market generally dries up in financial distress periods. Due to these, CDS spreads significantly increase independently of fundamentals of underlying entity in financial turmoil. Therefore, there are some limitations associated with CDS spreads as an indicator of risk of default (Grossman et al., 2010). Consequently, the argument that CDS spread may provide misleading information about credit risk in financial distress periods is quite important. CDS spreads of Turkey -to some extent- confirmed this in Even though there was not any major change in economic fundamentals which may negatively affect 5 year CDS spread of Turkey in 2008, it hit the peak on 24 October 2008 by reaching the level of 824 basis points after the emergence of global financial crisis. It was obvious that the global financial crisis would negatively affect the creditworthiness of Turkey and deterioration in some of Turkey s macroeconomic data in 2009 confirmed that. However, market s assessment of credit risk of Turkey via 5 year CDS contracts was quite exaggerated due to panic in financial markets. If it is considered that 5 year CDS spread of Turkey was just about 279 on 25 September 2008 and there was no major fundamental factor associated with credit quality of Turkey which might have led to 545 basis point rise of the CDS spread in one month period. 2.3 Information on Sovereign CDS Market Sovereign CDS are generally used to hedge credit risks of bonds issued by sovereign states or to take credit risk of a sovereign state via naked CDS to make profit. In comparison with other risk mitigation tools such as portfolio diversification or 7

8 securitisation, an investor could reduce his/her credit risk exposure at relatively low cost via CDS contracts. Holding naked sovereign CDS position is also a significant way of betting credit risk of a country. Since CDS contracts are daily valued in the market, there is no need for any credit event to make profit from a CDS contract; profits and losses as a result of daily valuation of sovereign CDS contracts are continuous (Report on Sovereign CDS, 2010). In other words, there is no need for any credit event, such as failure of reference entity to pay its obligations or declaration of moratorium, to take place; changes in market assessment of credit risk of a sovereign state which lead to change in CDS spreads are sufficient to make profit. There are mainly three types of credit event associated with sovereign CDS which are failure to pay, restructuring and moratorium. Failure to pay refers to sovereign s failure to pay principal or interest of any debt instrument. Restructuring means that as a result of worsening of its financial condition, a sovereign changes principal, interest payments, currency or maturity of its debt obligations. On the other hand, moratorium declared by an insolvent state is the legal delay of payment of debts (Report on Sovereign CDS, 2010). In addition to its functions as a tool for hedging or speculation, an investor can transfer credit risk of any bond by buying a sovereign CDS contract hedging credit risk of reference entity which issued that bond, so investor only takes the risk of counterparty which launched the sovereign CDS contract instead of credit risk of sovereign which issued the bond. Besides, a sovereign CDS is also used to evaluate and compare credit risk of different states in the world (Report on Sovereign CDS, 2010). Furthermore, there are some arguments criticising sovereign CDS markets because of speculators in the market who bet credit quality of sovereign states and speculative use of sovereign CDS leads to increase in borrowing cost of some sovereign states by widening CDS spreads. For example; due to fiscal problems, the yield of government bonds issued by Greece significantly rose in However, some participants in financial markets argued that increase in the number of speculators who hold naked CDS of Greece created additional negative tendency towards creditworthiness of 8

9 Greece and contributed to the rise of yields of Greek bonds. According to report released by Association Financial Markets in Europe, investors holding bonds issued by European States, had difficulty in finding CDS contract to hedge his/her exposure to credit risk due to illiquidity in CDS market in 2008.As a result, investors tended to reduce their exposure to credit risk by selling bonds (or any country related assets) from their existing portfolio and this sell off led to the increase in bond yields. Therefore, it can be concluded that illiquid CDS market may create additional burden on public debt by increasing bond yields (Briefing on Sovereign CDS, 2009). CDS s were first introduced into the financial markets in 1990 s. In 2004, the notional volume of outstanding sovereign CDS was 870 Billion USD and increased to Billion USD in June 2008 (Revoltella, 2010). According to Bank for International Settlements statistics, at the end of December 2010, this figure reached the level of Billion USD even though the world experienced global financial crisis in 2008 which is evaluated as the worst economic crisis by many economist since the great depression of The size of sovereign CDS market of some OECD countries relative to government debt is depicted in the following table (Briefing on Sovereign CDS, 2011). 9

10 Table 1: Volume of Sovereign CDS to Government Bonds (December 2011) Billions USD Country CDS Volume Government Bonds Sovereign CDS/ Debt (%) France 21, ,58 0,84% Italy 20, ,13 0,86% Germany 19, ,57 0,66% Brazil 18, ,31 1,18% Spain 15, ,04 1,57% United Kingdom 12, ,15 0,51% China 9, ,55 0,60% Japan 8, ,74 0,07% Mexico 8,62 511,67 1,68% Austria 5,93 311,98 1,90% Sources: DTCC, OECD. The table above indicates two important aspects of sovereign CDS market in the world. The first one is that volumes of sovereign CDS to outstanding government bonds, show that investors hold large volume government debts without hedging their positions with sovereign CDS contracts. The second point that can be derived from the table is that ratio of sovereign CDS contracts to bonds for the European Countries which are experiencing public debt problems such as Spain, is relatively high in comparison to other countries in Europe. In addition to these, if corporate CDS spreads are compared to sovereign CDS spreads, it is possible to recognise two differences between them. The first difference is that since the failure of sovereign state has rarely been observed in the history, it is difficult for market participants to estimate how much a sovereign state will recover after any single credit event such as bankruptcy, enhancing the difficulty of pricing sovereign CDS contracts because recovery rate of sovereign state after bankruptcy is an important 10

11 variable in pricing. The second difference is that sovereign CDS spreads are priced in a currency different from national currency because when any credit event such as bankruptcy happens, high devaluation of domestic currency is expected (ECB, 2009). 3. Regulations on CDS Market in European Union The prime motivator behind the European response to the regulations in the CDS market is the financial instability of governments, like Greece. CDSs written on Greek sovereign debt are blamed for increasing cost of borrowing for Greek government and decreasing investor confidence in its stability and finally causing a bailout threat in one of the Eurozone country. Buying a CDS without holding an underlying insurable interest ('naked CDS') is economically equivalent to short selling a bond, as the buyer benefits if the price of the CDS goes up. Several governments and regulators in Europe have expressed concerns with regard to CDS and their interaction with bond markets, and the fear that this could cause mispricing on bond markets and thus higher funding costs for governments. Proposals suggest that, like an insurance policy, a CDS should not be issued without the purchaser having an insurable interest. Regulators have expressed concern that this situation makes it difficult for them to detect the build-up of positions which could have implications for the stability of markets. Disclosure to the regulator could help regulators to identify when this is occurring, and deter aggressive strategies which could contribute to disorderly markets. Concern has also been expressed by some regulators that speculators may be driving down the prices of government bonds by using CDS. The concern of these regulators is that in the absence of information about sovereign derivative and bond transactions it is more difficult for them to detect the build-up of positions which could cause financial instability, as well as possible market abuse. 11

12 Buying credit default swaps without having a long position in underlying sovereign debt or any assets, portfolio of assets, financial obligations or financial contracts the value of which is correlated to the value of the sovereign debt, can be, economically equivalent to taking a short position on the underlying debt instrument. The calculation of a net short position in relation to sovereign debt should therefore include credit default swaps relating to an obligation of a sovereign debt issuer. The credit default swap position should be taken into account both for the purposes of determining whether a natural or legal person has a significant net short position relating to sovereign debt that needs to be notified to a competent authority and where a competent authority suspends restrictions on uncovered credit default swap transactions for the purposes of determining the significant uncovered position in a credit default swap relating to a sovereign debt issuer that needs to be notified to the competent authority. (Kaynak) Since entering into a sovereign credit default swap without underlying exposure to the risk of a decline in the value of the sovereign debt could have an adverse impact on the stability of sovereign debt markets, natural or legal persons should be prohibited from entering into such uncovered credit default swap positions. However, at the very first signal that the sovereign debt market is not functioning properly, the competent authority should be able to suspend such a restriction temporarily. The European Commission summoned its member states to Brussels in May 2010 to discuss the regulation of sovereign CDSs. The meeting culminated with the Commission backing a plan to ban some types of speculative trading in sovereign CDSs. Using the results from its investigation, the Commission proposed regulations on September 15, 2010, that will provide an EU-wide, coordinated response to disorderly markets and systemic risks. (European Commission, 2010) The EU s financial reform strategy includes emergency powers under which member states will be given the power to restrict or entirely prohibit particular types of CDS transactions. The proposed regulations would also introduce transparency requirements into some trades in CDSs relating to EU sovereign debt issuers. Persons with uncovered 12

13 positions or net short positions in sovereign debt would be required to privately inform member state regulators of their net short positions. 4. Credit Risk Pricing in CDS and Bond Markets Credit risk can be defined as the risk of loss resulting from failures of counterparties or borrowers to fulfill their obligations timely and completely. It appears in almost all financial activities, and therefore it is important to measure, price and manage it accurately. Credit derivatives and bond are the two easy and important ways to price the credit risk. Credit derivatives, mainly credit default swaps (CDS), the predominant type of them, provide an opportunity to trade and manage credit risk for the players in the financial sector. On the other hand, bond holders seek to gain interest incomes net of risk free rates by investing relatively riskier issuers and the level of interests reflect the premium offsetting the credit risk exposure. From this point of view there is a growing literature related to the interaction of credit risk pricing in derivatives and bond markets and the efficiency of price discovery in these markets. The purpose of this paper is to review the literature on whether the pricing of credit risk is consistent between the credit default swaps and bonds, which market (CDS or bond market) responds quicker to the changes in credit risk. This part of paper is essentially divided into three parts. The first part explains the pricing mechanism of the credit risk in the CDS and bond markets as well as the theory of equal credit risk pricing. In the second part, after the empirical findings on the equality of corporate bond spreads and CDS spreads are presented, the question which market has a leading role in price discovery is discussed. Emerging market case is 13

14 reviewed in the third part. Finally, conclusion part summarizes the findings of studies that are reviewed Credit Risk Pricing A single-name credit default swap (CDS) is a bilateral agreement designed explicitly to trade default risk (credit risk) between two parties. In a CDS, one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. The reference entity might be a corporation or a sovereign with an outstanding debt. The main credit events that entail the payment by the protection seller are reference entity s failure to pay, bankruptcy, restructuring, and repudiation or moratorium. When one of the aforementioned credit events occurs, the contract expires and the payment is made equal to the par value of bond (physical settlement) or equal to the difference between par value and the recovery value of the bond. Therefore, CDS provides the transfer of credit risk from protection buyer to protection seller, and the price of this protection, named CDS spread, can be defined as the price of credit risk. It is clear that the riskier (i.e. low rating, high leverage ratio) is the reference entity, the higher CDS spread should be paid by the protection buyer. When the bond market is considered, the yield on a bond consists of two components: The yield on a default-free bond with same maturity and a premium over it to compensate for the risks. The part of risk premium attributable to default risk is called credit risk spread. Similar to the CDS spread, the riskiness of the issuer is the main determinant of credit risk spreads in the bonds. In theory, absence of arbitrage states that the pricing of credit risk in these markets should be equal under the following assumptions. Firstly, it is assumed that players in the market can short both corporate bonds and risk-free bonds. Secondly, interest rates are constant and bonds are sold at par. Finally, transaction costs are ignored (Hull, 2004). Duffie (1999), Houweling and Vorst (2005) shows that when an investor buys a 14

15 t-year par bond and buys credit protection on that reference entity for t-years in the credit default swap market, he eliminates the default risk associated with the bond. Therefore, the net return that investor gets when he buys a defaultable bond and a CDS should be equal to t-year risk-free rate. If the net return is higher shorting risk-free bond and buying defaultable bond with a CDS will create an arbitrage profit. If the net return is lower, shorting a risky bond, selling a CDS and buying a risk-free bond create an arbitrage profit. As a result, those papers conclude that the credit default spread should be equal to the spread between defaultable and risk-free bond (credit risk spread) The Theoretical Arbitrage Relationship in Corporate Bonds and CDS Market The theoretical arbitrage relationship was firstly examined between corporate bonds and corporate CDS. Zhu (2006), which analyses 24 investment grade firms of US (mostly), shows that the prices of credit risk in the two markets are very close to each other when the swap rates are used as a benchmark risk-free rate. Similarly, Houweling and Vorst (2005) and Blanco et al. (2005) use the swap rates and both of them empirically put forward that credit risk is priced significantly equal for investment grade bonds. On the other hand, Longstaff et al. (2005) concludes that there is significant difference between bond yields and CDS spreads for investment grade firms when treasury rate is used as a benchmark risk-free rate. Thus it can be said that the empirical results are in line with the theoretical arbitrage relationship when swap rates are used instead of treasury rate. Hull (2004) explains that the difference occurs when treasury rates are used, due to noncredit risk reasons such as taxation, capital requirements and liquidity discrepancies. Although most of the studies assert that credit risk is generally priced equally in CDS market and bond markets, possible reasons for price mismatch between bonds and CDS are also explained in various papers. Dotz (2007) says that the most important reason is the low level of liquidity and the high costs of shorting accordingly. It prevents the exploitation of arbitrage opportunities across markets thereby occurring different prices. Duffie (1999) claims, the theoretical arbitrage relationship holds only for the floating 15

16 rate instruments. However, Dotz (2007) states that limited number of such financial instruments makes it difficult to conduct empirical studies with them. This might be another reason why some empirical studies are not perfectly in line with the theory. Blanco et al. (2005) says that some CDS contracts define a reference entity instead of a specific asset. This gives the protection buyer an opportunity to choose the cheapest to deliver option. In this situation protection seller comes up against a loss higher than expected, because the delivered bond s value is less. As a result, protection sellers demand higher spreads for CDS contracts which results in wide price differences between two markets. After the equal pricing of credit risk between the CDS market and bond market is showed empirically in some developed and liquid markets, the investors and researcher focus on which market responds quicker to changes in credit risk. The theory suggests that prices adjust simultaneously when there is new information on credit risk. However, market participants believe that efficiency of price discovery in CDS market should be higher due to the structural differences between markets. Longstaff et al. (2005), which refuses the equal pricing of credit risk between CDS and bond markets claims that credit default swap spreads lead changes in corporate bond yields. He examines the lead-lag relationship between these markets and finds clear evidence that information firstly flows into CDS market and then into the bond market. As per Blanco et al. (2005), price discovery mainly takes place in the CDS market. They claim that credit default swaps lead the credit spreads because price discovery generally occurs in the market where trading happens in the easiest way between informed traders. It is clear that CDS market has an advantage over bond markets in terms of these criteria because it is easier to go short or long in CDS trading. This finding is supported by Forte and Pena (2009) which emphasizes the structural differences between these markets and confirm the leading role of CDS market with respect to the bond market. 16

17 Zhu (2006) shows clear differences between the firms studied, with the liquidity of the instruments seeming to play a role. He studies firms from both US, Europe and Asia and he suggests that the CDS market dominates among US firms whereas the bond market plays the leader role among European and Asian firms where liquidity of CDS market relatively low. Zhu (2006) measures the liquidity using the CDS bid-ask spreads and finds evidence that liquidity of the CDS market affects the spread differences and contributions to price discovery. Similar to the findings of Zhu (2006), Norden and Weber (2004, 2009) point out that CDS is the leader in price discovery with respect to US firms but for European firms. The CDS and bond markets contribute to price discovery similarly due to the segmentation of market. According to these papers, the absence of the short sale and funding restrictions pave the way this leading feature of CDS market. However, Dotz (2007) focuses on European firms with the data that covers the period until 2006 and concludes in Europe, CDS market slightly dominates the price discovery, too. His findings about the European market tend to be different due to the further development of CDS market in Europe during this period Emerging Sovereign Bond and CDS Market As discussed above, most of the early studies focus on the corporate bonds to test the relationship between bond and CDS premiums. However, the more CDS market becomes widespread, the more reference entity such as sovereign bonds start to be insured against default with credit default swaps. Researcher wondered whether the relationship between CDS and bond markets exists in the sovereign market. Specifically emerging sovereign bonds, which have distinctive characteristics compared to corporate bonds, are at the centre of research. According to statistics published by Bank for International Settlements, ratings of the sovereign reference entities are generally lower than those of corporate. Moreover, the emerging market sovereign bonds are generally sold below par and the size and volume of the market is very low. Thus, the findings of 17

18 studies on sovereign bonds and CDS market are expected to reveal important information. Chan-Lau and Kim (2005) do not find strong equilibrium price relationship between CDS and bond markets when they work on the data of eight emerging markets. They claim that while the liquidity of bond markets is high enough, CDS market for sovereign bonds are dominated by a few number of financial players (especially by banks). This limited liquidity in credit default swaps prevents the price convergence between CDS and bond premiums. Ammer and Cai (2007) deal with nine emerging market economies. This paper reveals that while there is no equilibrium price relationship between CDS and bond markets in the short run, prices tend to converge in the long run. According to their study, the deviation from equilibrium occurs in emerging market sovereigns because of these countries below investment level ratings and cheapest to deliver option embedded in credit default swap pricing. Adler and Song (2010) conduct a study on 16 emerging market sovereigns and reject the hypothesis stating credit risk in these sovereigns is priced equally between CDS and bond markets. According to this study, bond prices are generally not at par in emerging markets. After removing the impact of below par priced reference bond on CDS spreads, they fail to reject the hypothesis in most of the countries. Li and Huang (2011) examine 22 emerging markets for the period of Results of this research show that in the 19 of the 22 sample emerging markets, pricing of credit risk substantially equal in CDS and bond markets. The result is different from prior studies because, the time period is more recent and meanwhile CDS market becomes more liquid and developed. Findings of studies on emerging market sovereigns put forward the importance of developed and liquid markets in CDS and bond markets. While empirical results of data concerning early years do not provide strong evidences for equal pricing of credit risk, 18

19 researches on recent data shows the existence of equilibrium relationship between CDS and emerging sovereign bond markets. It might be concluded that removing barriers for arbitrage opportunities and increasing liquidity will increase the accuracy of credit risk pricing in these markets Conclusion Activity in credit derivatives has accelerated as users recognise the growing importance of managing credit risk since late 1990s. A substantial body of empirical work has developed about credit risk pricing instruments correspondingly, with an emphasis on bonds and credit default swaps in the last decade. Although the data is limited, studies provide evidences about the accuracy and efficiency of credit risk pricing in these markets. Studies show that credit risk is priced equally between the CDS and bond markets for the investment grade bonds when both markets are liquid enough and technical and structural factors do not prevent arbitrage opportunities. Therefore, investment grade US corporate bond market has been the first market where equal pricing is detected. As the CDS market became more liquid and developed theoretical arbitrage relationship has been discovered in European corporate bond market, too. The same equilibrium relationship between CDS and bond markets is questionable in emerging markets. Most of them does not have investment level ratings, not liquid enough and include technical barriers for converging of spreads as a measure of credit risk. However, studies put forward that increasing volume and market size in sovereign bond and CDS market provide the equality at credit risk pricing in these two markets. Scholars also investigated which market responds the credit risk fluctuations earlier. They suggest that in a liquid and developed market environment, CDS market leads the bond market in credit risk pricing. As a reason of this, they claim that flowing of new 19

20 information and trading of information firstly occurs in CDS market. It is more flexible and less capital is needed to take a long position in CDS market. As the volume and size of CDS market improve, interaction with the bond market becomes clearer and poor liquidity problem will be solved. Further analysis can be done with the data of longer period focusing on the sovereign bond markets. In addition, speculative grade corporate entities remain as an open point for further research. The prospective findings may be useful for financial players who trade in different markets to manage the credit risk successfully. 20

21 References Adler, M., Song, M., 2010, The Behavior of Emerging market Sovereigns Credit Default Swap Premiums and Bond Yield Spreads, International Journal of Finance and Economics, 15: Ammer, J., Cai, F., 2007, Sovereign CDS and Bond Pricing Dynamics in Emerging Markets: Does the Cheapest-to-deliver Option Matter?, International Finance Discussion Paper, No. 912, Federal Reserve Board. Credit Default Swap Market, (2011), Bank for International Settlements Statistics Barbosa L., Costa S. (2010) Determinants of Sovereign Bond Yield Spreads in the Euro Area in The Context of Economic and Financial Crisis, Banco De Portugal Economics and Research Department Working Paper,. No.22/ 2010: Blanco, R., S. Brennan, and I. W. Marsh, 2005, An Empirical Analysis of the Dynamic Relationship Between Investment Grade Bonds and Credit Default Swaps, Journal of Finance, 60: Briefing on Sovereign CDS, International Securities Lending Association (ISLA), Published Briefing Papers on Short Selling, 3 June pp Chan-Lau, J.A., Kim, Y.S., 2005, Equity Prices, Bond Spreads, and Credit Default Swaps in Emerging Markets, ICFAI Journal of Derivatives Markets, 2: Coudert V., Gex M. (2010). Credit Default Swap and Bond Markets: Which leads the other?, Banque de France Financial Stability Review, Derivatives- Financial Innovation and Stability, No.14/ July 2010 : Trade Information Warehouse Reports, Depository Trust and Clearing Corporation (DTCC), (2011). 21

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