CDS does not trigger sovereign debt price fluctuations, says Edhec

There is no causal link between credit default swaps (CDS) and sovereign debt prices, new research published by the French EDHEC-Risk Research Institute indicates.

The research performed a theoretical and empirical analysis of the relationship between the price of eurozone sovereign-linked credit default swaps (CDS) and the same sovereign bond markets during the eurozone debt crisis of 2009-2011. It was run by Dominic O’Kane, affiliated professor of finance at EDHEC Business School.

O’Kane’s subsequent working paper, entitled “The Link between Eurozone Sovereign Debt and CDS Prices,” tests the claim speculative use of CDS by market participants had caused or accelerated the rapid decline in 2010-11 of bond prices in eurozone periphery countries, which led the European Parliament and member states’ to permanently ban naked CDS in October 2011.

The research shows CDS spreads do not drive sovereign bond spreads in all circumstances, and that in various countries and at various times, the opposite effect is present.

EDHEC-Risk said its results are in line with those of a recent report from the French regulatory authority, the AMF, entitled “Price Formation on the CDS Market: Lessons of the Sovereign Debt Crisis (2010- ).”

However, it added that certain conclusions in the AMF report should be analysed with care. “A causal link between rising CDS spreads and their decision-making character has not been established or proven in the report, which moreover does not include a formal test on the subject,” said EDHEC-Risk.

O’Kane argued CDS spreads are a “cleaner and more transparent measure of market-perceived credit than bonds since CDS are not limited by supply, are as easy to buy as to sell, and have a lower cost of entry.”

“It would be wrong to suggest that the 200bp level highlighted by the AMF report is the level at which the CDS market “causes” the bond market spreads to increase. A more valid explanation would be that the CDS market establishes a truer estimate of forward-looking sovereign risk which is not reflected in the bond market where some market participants are required to hold high-quality Eurozone debt,” he added.

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