Review of the Article on Credit Derivative Market

Introduction

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The term credit derivative, in finance, refers to the various techniques or instruments designed to separate and transfer the credit related risks in the event of payment default by a sovereign or corporate borrower. This technique thereby transfers the defaulted debt to another entity other than the debtholder or lender (Hassan, Ngene, & Yu, 2015, p. 240). Credit derivative market thereby refers to the physical or virtual economic space within which the credit lenders and borrowers operate. This paper thus reviews an article on the related topic of credit default swap. The article is titled Sovereign Bond Spreads and Credit Swap Premia: Cointegration and Causality (Garcia, Valle, & Martin, 2014). Credit default swap (CDS) in this context refers to the agreement on the financial swap, whereby the CDS seller compensates the buyer (loan creditor) in the event of any loan default by the debtor. Simply put, the CDS seller insures the buyer against the defaulting of a reference credit.

The research document thereby presents the analysis of all the possible associations between the CDSs premia and sovereign bond spreads. Hence, the paper seeks to determine whether the CDSs are vital tools for the measurement of sovereign risks; either independently or jointly by considering the progression of their values (Battistini, Pagano, & Simonelli, 2014, p. 231). The research obtained its data from several countries, which represented different regional economies, both for the developed and the emerging economies. The countries included in this analysis include France and the UK as relatively stable economies from the European regions; Italy and Spain as economies that have been severely impacted by the economic crisis.

The study included Japan as an Asian country; and Chile, Brazil, and Argentina to represent the Latin American regions. Finally, Germany and the U.S. have been used as the benchmarks for the risk-free assets (bonds) in differential calculations. The core objective of the study was to guesstimate the equilibrium correlations existing between the sovereign bond spreads and the CDS premia. To be precise, the research questions answered in this paper are; (i) Do these two parameters converge despite the severe market frictions? (ii) Of the known parameters, which one is the best for the sovereign risk measurement? (Garcia, Valle, & Martin, 2014, p. 47). Moreover, the research paper is well arranged into distinct sections such as the Literature Review, Correlation Analysis, Empirical Methodology and Results, and finally the Conclusion section.

Literature Review

The study literature reveals that there have been several econometric studies undertaken to establish whether there is a correlation between the sovereign bond spreads and the CDS premia while disregarding or assuming the market frictions that may hinder their convergence. For instance, Blanco, Marsh, and Brennan (2005) assessed the correlations between the CDSs and the risk premiums at the corporate levels. Their study revealed that the CDS prices are significantly greater than the credit differentials provided the research duration remains longer. Similarly, Hull, Predescu and White (2004) conducted a study that examined the association between the differentials of the CDSs and the bond yields. Second, they executed a series of tests in order to examine the effects of Moodys ratings announcement on the CDSs premia variations. Taking the European markets as the study benchmark, Alexopoulou, Georgescu, and Andersson (2009) also scrutinized the impacts of the price of credit risk on CDS and corporate bonds. Their study finding was that there existed a correlation between the two markets in long-term.

Focusing their analysis on the determination of the proliferation in the risk premiums in Europe, Attinasi, Nickel, and Checherita (2009) conducted a study from the beginning of the 2007 crisis. The study emphasized on the economic variations and the new governmental measures aimed at reducing the monetary deficits. A similar study was conducted by Scheicher and Fontana (2010) on the association between CDS premium and the sovereign bonds spreads for 10 states within the European regions. As well, Broto, Sebestyen, and Perez-Quiros (2011) conducted analysis on the same correlation topic for ten nations including both European and the U.S. states. In support of all the literatures listed by the above research document, the paper concludes that as the turbulences within the sovereign debt markets increase, the CDS premia and risk spreads also continue to rise rapidly. Thus, there will still be a persistent interest by many researchers to conduct studies on this subject (Garcia, Valle, & Martin, 2014, p. 58). However, the study still intends to explore further from scientific literature works on the same topic; hence the paper's literature is still a subject to development.

Correlation Analysis

The countries that were considered in the analysis by this paper were France, Spain, Japan, the UK, Italy, Argentina, Chile, and Brazil. According to the research paper, these countries are of different economic strengths or situations, and they are also of the various geographic settings. Before the empirical study, the graphical examination of the variables was done, with the view of revealing the possible association between the two parameters under the study (Garcia, Valle, & Martin, 2014, 48). However, the data obtained for this study was not continuous since certain periods did not have concrete information on the topic. The discontinuity was also as a result of the inadequate transparency within the market.

In the analysis, the spreads calculation in absolute condition of the CDS premium of the U.S. or Germanys Treasury bonds were added to the spreads of the bond under the inquiry. The objective was to estimate the national risk-free asset prices. However, the rationale behind the addition of the US or Germanys CDS premiums to the spreads relied on the intended objective of attaining the absolute risk measure on the bond instead of the relative one (Battistini, Pagano, & Simonelli, 2014, p. 246). This strategy allowed for the estimation and modification of calculus to match the comparison concept of the bond spreads against the real risk-free assets (Battistini, Pagano, & Simonelli, 2014, p. 217). Elsewhere, the analysis of the spreads in Chile, Brazil, and Argentina involved the employment of the return of EMBI Global Diversification in order to substitute the bond interest rates.

In the papers analysis of the cases of Italy, France, and Spain, the evolution of the CDSs premia and 10-year bond spreads of public debts were scrutinized graphically, and the levels of positive association between the two markets construed. The analysis thereby suggested that CDS may play a very integral but de-stabilizing role. There was a higher difference between the bond spreads and CDS premia in Italy and Spain (Garcia, Valle, & Martin, 2014, p. 49). The paper thereby deduced that these countries tend to be extra sensitive to the influences of a possible hypothetical activity and contagion. In the case of Spain, the spreads began to escalate above the CDSs premia, and the differences between these two parameters hit 150 base points by the beginning of 2011. As such, the prevailing pessimism on the contagion within the markets resulted in the fall of investor confidence in Spain.

In the case of Japan and the UK, the study analysis introduced new findings on the market behaviors. In these countries markets, the study deduced that there was a very low degree of relationship between the two study variables. For instance, in the case of the United Kingdom, two underlying reasons can explain the existence of the weak correlation. The first reason is the difference in the yield curves of the Euro and Pound. The second reason was stated to be due to the fact that there is insufficiency in the information about the CDSs premia as indicated by December 2012 (Wang, Yang, & Yang, 2013, p. 593). The conclusions for Japan were similar to those of the UK; however, the greatest difference observed in the Japanese case between the CDS premium and the spreads. As such, the returns on Japanese public debts were far much less when compared to that of the U.S. and Germany. In simple terms, the spreads were negative. Nonetheless, for the case of the Latin American countries including Chile, Brazil, and Argentina, the relationship found between the risk premium and CDS during the study period was relatively high.

Out of all the countries evaluated in this research article for the correlation of the two variables, the country that presented the greatest degree of correlation was Italy, which was closely followed by Spain. Moreover, out of all the proposed empirical models, the paper can deduce that the indicators are closely associated, especially regarding their behavioral analysis over an extended time bound. The models thereby lead to a conclusion that there is a very close association between the bonds spread and the CDS premia.

Empirical Methodology and Results

The concluded close association between the bonds spreads and the CDS premia do not necessarily mean that there is an actual/direct dependence of the two parameters in the real market. This assertion may be due to the fact that a long-term trend in a similar direction, may result in erroneous conclusions since one may imagine that the parameters are essentially linked to each other through regression. Consequently, to demonstrate the possible direct link between the parameters under study, the research paper employed the use of Grangers Causality tests and Co-integration. The integral aim of this method was to determine whether the data series obtained will move together in the same direction over long-run and whether the established differences are stable (Norden & Weber, 2009, p. 532). The co-integration analysis was split into two stages: (i) checking if the series of prices are fixed, and (ii) determining the proposed co-integration ranges by Johansen in 1991 (Johansen, 1991). In the second phase of this methodology, the study analyzes the Grangers measures of causality. This method employs the enlarged concepts of correlations to causalities, hence regardless of a positive causality test result, there should never be a conclusion that there is a direct correlation.

However, due to the fragmentary arguments on the existing relationship between the variables under the analysis, three steps were incorporated into the study methodology. These steps included: (i) Series stationarity analysis; (ii) Determination of the co-integration degree; and finally, (iii) the Causality tests (Garcia, Valle, & Martin, 2014, p. 52).

Through different tabular analysis, the study summarized that the chains of the CDS premia and those of the bond spreads are mutually non-stationary; hence they follow arbitrary walk patterns. Additionally, the study obtained positive results for the countries that were on the Johansens co-integration test, where the EMBI also often refers to the bonds issued in US Dollars. Moreover, from causality test analysis, the study deduces that CDS premiums caused the bond spreads of almost all the countries under the study. The null-hypothesis that CDS premia do not cause bond spread, was thereby rejected. Regardless of the bi-directional causal association, the manifestation is in favor of the CDS premia. The study findings revealed this bi-directional relationship to be st...