The Link Between Sovereign CDS And Government Bond Prices

With an increasing government debt level and worsening fiscal situation after the sub-prime crisis, the risk of sovereign default keep increasing, especially for European countries, and finally leads to the Euro-zone debt crisis. The debt crisis provides an opportunity for a growing sovereign CDS market, which draws more and more attention, as well as discussions. It is critically important for both the Chinese government and companies to take sovereign debt into consideration when make investment decisions, which is based on an thorough understanding of the sovereign markets. By studying the link between sovereign CDS prices and government bond prices, this paper tries to discuss if sovereign CDS market plays a role in market risk hedging, as a supplement to government bond market and improve market efficiency, and whether it amplify the debt crisis or not.This paper mainly focuses on the sovereign CDS market and its relationship with government bond market, based on the evidence from "PIIGS" countries. We find that the theoretical equality between sovereign CDS price and government bond spread does not always hold, nor does the long term relationship between these two markets, which is more likely to hold when government bond market leads sovereign CDS market. Moreover, we study the impact of European debt crisis and find evidence that the crisis enlarge the price discrepancies between these two markets. But there is no evidence that the Greek debt crisis has a spillover effect on the other four countries. Thus, its amplification effect on the crisis is limited if there is. Although the Euro-zone debt crisis boost sovereign CDS market, which lead the government bond market in some case and is more sensitive to new information, the sovereign CDS market is still in its infancy after all, and are less efficient than the government bond market, which is larger in market volume and higher in liquidity.