Aurora Borealis
1 February 2013 CFA Institute Journal Review

Default Risk of Advanced Economies: An Empirical Analysis of Credit Default Swaps during the Financial Crisis (Digest Summary)

  1. Thomas M. Arnold, CFA

The authors test whether Western European sovereign credit default swap (CDS) spreads capture a transfer of risk from the private sector to the public sector. If governments are expected to insure the financial sector during a time of crisis, then after 2008, sovereign CDS spreads should reflect the extra risk of providing this insurance to the private sector. Empirical evidence appears to support that such a risk transfer occurs.

What’s Inside?

The authors demonstrate empirically that private sector risk can be transferred to the public sector. In the case they examine, this transfer is the result of a government supporting its financial system through the 2008 financial crisis. According to their study of Western European sovereign credit default swap (CDS) spreads from January 2007 through April 2010, the amount of economic activity within the financial sector of a given country, measured proportionately and relative to the return–risk contribution locally and globally, is strongly related to the behavior of CDS spreads after they control for a number of other factors. The authors contend that this finding is evidence of a risk transfer from private entities to the government as a result of the government’s actions.

They also find that CDS spreads display stronger cross-sectional correlation than associated equity securities. This result supports earlier findings that international equity portfolios provide more diversification benefits than international portfolios of sovereign credit. Additionally, the health of the global economy, as opposed to local conditions alone, has a significant effect on the CDS spreads in the authors’ study. The spreads for financial institutions in European Monetary Union (EMU) countries seem to be more sensitive to problems than those in nonmember European countries, which suggest that implicit EU-wide "bailouts" are anticipated by participants.

How Is This Research Useful to Practitioners?

Practitioners can benefit from understanding that sovereign credit can be influenced by government policies that allow for the transfer of risk. In particular, risk can be transferred to sovereign credit from a given private sector within a country because the government can implement policies to support that particular sector. Essentially, an investor in sovereign credit may find that risk, rather than representing the whole economy of the country, is actually weighted toward government-supported sectors within the country’s economy.

Because of this risk transfer based on government support of a given industry, investors may benefit more (from a diversification perspective) by forming their own portfolios of securities from given countries/economies than by investing in sovereign credit.

How Did the Authors Conduct This Research?

The authors use weekly data from January 2007 through April 2010, although the data are sometimes used on a monthly and quarterly basis. The CDS data are from 18 countries that represent the Western European sovereign CDS market.

First, they perform a principal component analysis. The data display a commonality that captures 75% of the variation within the data, compared with 65% for associated equity indices. Next, looking at time-series properties, they find that some data display nonstationarity. Consequently, they conduct further analysis using actual levels and using first-differences by converting the data to changes in the level for each period rather than the actual level for each period. The first-differenced data adjust for the potential of nonstationarity, which could impede statistical testing.

To investigate the influence of a given country’s financial sector on CDS spreads, the authors measure the financial sector proportionately (market capitalization of the financial sector divided by market capitalization of the country’s entire market) and by the growth of the financial sector each period (average percentage change in bank assets). To capture the contribution of the financial sector to overall market return–risk, they generate orthogonal measures of the financial sector returns within the local market along with a similar measure for the financial sector within the global market.

The findings indicate that that exposure (proportional and growth measures of the financial sector) to the financial market affects CDS spreads. Furthermore, the return–risk contribution of the financial sector globally and locally affects CDS spreads. This latter effect becomes amplified by the given level of exposure to the financial sector. This amplification is much higher after the financial crisis. Other potential contributors to CDS spreads, as determined in previous research, are modeled with control variables.

The authors determine with further investigation that no particular country is responsible for generating the result and that the global financial sector is important within individual-country analysis. Furthermore, EMU member countries within the sample are more sensitive to the return–risk contribution of both the local and global financial sectors than nonmember European countries. Finally, when the authors consider exposure to the subprime mortgage sector, such exposure does not appear to affect CDS spreads.

Abstractor’s Viewpoint

This article is interesting even beyond the analysis pertaining to the financial crisis. The ability of a sovereign to transfer private sector risk to the public sector through a government’s policies of support for a particular sector is intriguing from a political risk perspective. Taken from a different viewpoint, if a government decides to nationalize an industry, an investor would certainly lose the ability to directly invest in the formerly private industry but may be able to recapture some of that investment through a sovereign CDS investment.

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