Market frictions and the pricing of sovereign credit default swaps Articles uri icon

publication date

  • February 2016

start page

  • 223

end page

  • 252

volume

  • 60

International Standard Serial Number (ISSN)

  • 0261-5606

Electronic International Standard Serial Number (EISSN)

  • 1873-0639

abstract

  • This paper contributes to the general understanding of how sovereign CDS prices are formed by studying the information content of pricing errors generated by a non-arbitrage model. We implement a price-discrepancy measure in the spirit of the noise measure introduced by Hu et al. (2013) in the Treasury Bond market, and analyze its main determinants in panel data analysis. The main results show that sovereign CDS pricing errors are systematically related to higher bid-ask spreads. The evidence in this paper also suggests that exits of capital arbitrage during distressed periods, as measured by changes in net offsetting, can be associated to larger pricing errors in sovereign CDS from advanced economies, thereby supporting the main claims of the limit-to-arbitrage theories. These findings are robust for the most common CDS pricing models employed in the industry and different estimation techniques. (C) 2015 Elsevier Ltd. All rights reserved.

keywords

  • credit default swaps; noise measure; illiquidity; capital arbitrage; corporate yield spreads; term structure; liquidity; risk; information; arbitrage; models; option; bonds