Short-Term Determinants of the Idiosyncratic Sovereign Risk Premium: A Regime-Dependent Analysis for European Credit Default Swaps

Giovanni Calice, RongHui Miao, Filip Štěrba, Bořek Vašíček

This study investigates the dynamic behavior of the sovereign CDS term premium for a group of European countries. The CDS term premium can be regarded as a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets in real time. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium into two unobserved components of statistically different nature (stationary and nonstationary) and study the determinants of their short-term dynamics. Specifically, we link these components in a vector autoregression to various daily observed financial market variables. We find that decomposition into the two components is vital for understanding the short-term dynamics of the entire CDS term premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, our results suggest that the response of the CDS term premium to shocks to financial variables is regime-dependent and can be ten times stronger during periods of high volatility.

JEL codes: G01, G15, G21, G24

Keywords: credit default swaps, Markov switching model, sovereign risk, State space model, term premium

Issued: December 2013

Download: CNB WP No. 13/2013 (pdf, 1.1 MB)