CDS Spreads: An Empirical Analysis of European Countries

Abstract

This thesis investigates how credit default risk as reflected in credit default swap (CDS) spread is transferred in the European countries. The first part observes the default risk transfer between the sovereign debt and the domestic financial institutions of the European countries during the European sovereign debt crisis. The previous literature indicates that a "two-way feedback" effect exists between the two sectors. In this part, the bailouts by the European Financial Stability Facility are used as breakpoints to examine the changes in the default risk transfer between the two sectors. The results suggest that the two-way feedback effect does not exist after the first Greek bailout. The shocks in the financial sector transmitting to the sovereign debts become either negative or insignificant in both the short and the long runs. Subsequent to the first Greek bailout, the private-to-public risk transfer no longer exerts significant impacts, regardless of later bailouts issued to the other countries.
The second part further examines the structural regimes in the cointegration relationship of default risk between the two sectors. The empirical results indicate that the private-to-public risk transfer becomes stronger in the 'atypical' regimes, which covers the crisis periods. The approach of identifying changes in regime is robust, and the detected thresholds also confirm that it is reasonable using the EFSF bailout events as breakpoints.
The final empirical chapter focuses on the cross-country cointegration of sovereign default risk, and takes note of the role of investor sentiment in explaining the risk transfer. The findings show that investor sentiment is capable to predict regimes in the sovereign default risk in the short run. During crisis periods, the trench of the sovereign default risk is wider, but the elasticity is smaller, indicating more difficulties for the countries to close the gap of the default risk.