CDS-Bond Basis Dynamic and Credit Spread Price Discovery: A Test for European Corporate and Sovereign Bond Markets

Abstract

This work analyzes the possible links between CDS premiums and bond spreads, with reference to both Eurozone sovereign and corporate markets, within the period 2011-2018. The main goal of this work is to provide more up-to-date results about the theoretical equivalence between the CDS premium and the credit spread of the underlying bond, and about the price discovery process of the credit risk between the CDS market and the bond market. While, theoretically, the CDS-bond basis must tend to zero, the analysis on all the considered markets has shown that it results to be constantly away from parity and, more specifically, positive on average. The analysis of the price discovery process of the credit risk between the CDS market and the bond market, analyzed by means of the VAR and VECM models, confirms the leader role of bond spreads for almost all the analyzed entities. These evidence could be useful for arbitrageurs, who want to take advantage of potential market inefficiencies, and for regulators interested in guaranteeing the financial system stability through timely and correct inclusion of all available information in the security prices, avoiding any adverse selection issue.

Effective transfer entropy to measure information flows in credit markets

“…The results for the core countries lead to the same conclusion of Coudert and Gex (2013) and Fontana and Scheicher (2010), who found a leadership of the bond market in low yield sovereigns during the high stress caused by the financial crisis. Similar outcomes are also derived by Patane `et al (2019), who found a dominant role of the bond market for Germany and France during the period between April 2011 and May 2014. According to the results of Coudert and Gex (2013) and Fontana and Scheicher (2010), the bond market leads the price discovery process in countries exhibiting low bond yields.…”

“…They did not find evidence of cointegration between the two markets during calm period, and conclude that the bond market led the price discovery process during the post-crisis period. Another recent analysis has been conducted by Patane `et al (2019), who analyzed the link between the CDS premium and the bond spread for core and peripheral countries in the Eurozone during a wider time span, ranging from 2011 to 2018. When cointegration was found, they concluded that the bond market played a leader role in the price discovery process during the period of financial distress, and only during the subsequent period between 2014 and 2018 the CDS market gained more importance.…”