A Macrofinance View of U.S. Sovereign CDS Premiums

Abstract

Premiums on U.S. sovereign credit default swaps (CDS) have risen to persistently elevated levels since the financial crisis. We examine whether these premiums reflect the probability of a fiscal default—a state in which a balanced budget can no longer be restored by raising taxes or eroding the real value of debt by increasing inflation. We develop an equilibrium macrofinance model in which the fiscal and monetary policy stances jointly endogenously determine nominal debt, taxes, inflation, and growth. We show that the CDS premiums reflect the endogenous risk‐adjusted probabilities of fiscal default. The calibrated model is consistent with elevated levels of CDS premiums but leaves dynamic implications quantitatively unresolved.

Sovereign credit risk and exchange rates: Evidence from CDS quanto spreads

“…This suggests the occurrence of currency devaluation during particularly bad states of the economy that tend to coincide with a high marginal utility of the representative agent. This interpretation is similar to the equilibrium models of Augustin and Tédongap (2016) and Chernov, Schmid, and Schneider (2017), who characterize the large risk premia demanded by risk-sensitive investors for selling CDS protection on sovereigns in developed economies. In the next section, we directly measure the risk premiums associated with default-contingent devaluation.…”

The U.S. Public Debt Valuation Puzzle

“…In rational bubble models, the debt/GDP ratio declines over time. Fourth, the rise in the sovereign CDS spread after the Great Financial Crisis, documented by Chernov et al (2020); Pallara and Renne ( 2019), seems at odds with a rational bubble in Treasury debt.…”

“…, where χ t,t+h is an indicator variable that is one when the government defaults between t and t + h. We assume full default to keep the proof simple, but this is without loss of generality. Chernov et al (2020) and Pallara and Renne (2019) study the response of CDS spreads to news about the fiscal surplus. claim as:…”

Foreign Safe Asset Demand and the Dollar Exchange Rate

“…Our model abstracts from the fact that the value of Treasury bonds is ultimately derived from the government's budget constraint. Chernov, Schmid, and Schneider (2020), Jiang (2019aJiang ( , 2019b, Jiang et al (2019b), andLiu, Schmid, andYaron (2019) study how the government budget affects currency returns and bond valuation.…”