Erdem Aktug

Office Information Rauch Business Center Room 211 Tel: 610-417-8443 Email: rea204@lehigh.edu

Working Paper

The Dynamic Relation Between Sovereign Bond & Credit Default Swap Markets: Empirical Evidence From 2001-2007 Period

Erdem Aktug
Doctoral Candidate
College of Business & Economics
Lehigh University
rea204@lehigh.edu

Geraldo Vasconcellos
Professor of Finance
College of Business & Economics
Lehigh University
gmv0@lehigh.edu
(610) 758-3440

Youngsoo Bae
Professor of Economics
College of Business & Economics
Lehigh University
yob206@lehigh.edu
(610) 758-5342

Abstract

This paper evaluates the dynamic relationship between sovereign credit default swap (CDS) and bond markets for the 2001-2007 period. We compare monthly five year CDS premiums with Emerging Market Bond Index Global stripped spreads for thirty sovereign bonds, providing a thorough analysis of sovereign credit markets with an extensive and high quality data set. Our first discovery is that sovereign CDS and bond markets have become more integrated over time. Second, we discover sovereign bond markets’ leading role in the price discovery mechanism. This result is in sharp contrast with studies on corporate credit markets and it reveals the inefficiencies surrounding sovereign credit markets. Third, we provide an econometric methodology which is more meaningful in sovereign context. Consequently, we propose a new measure to check for the appropriate error correction mechanism in the Vector Error Correction Model (VECM) framework. The results of our study possess valuable information for regulators, investors, and traders of sovereign securities.

Last Update: September 2, 2009

For further information, please contact me at rea204@lehigh.edu