Managing and trading sovereign risk using credit derivatives and government markets

Managing and trading sovereign risk using credit derivatives and government markets Purpose – The sovereign debt crisis in Europe increased the demand for asset manager worldwide to monitor and manage their sovereign risk. While using information from the credit derivatives and bond markets has been used widely in the corporate sector its usage for sovereign risk is novel. The paper aims to discuss these issues. Design/methodology/approach – The basis between a sovereign credit default swap (CDS) and the government bond contains valuable information for assets managers and traders alike. The paper demonstrates the use of the basis between the announcement date and the issue date of a new government bond to decide whether an investment in this bond is profitable. Findings – With this strategy, the authors are able to generate both over all excess returns with a European sovereign portfolio since 2008 as well as a constant outperformance of simple average euro government bond portfolios. The paper furthermore tests the economic rationale behind this trading strategy and confirms prior findings from the corporate market. CDS market liquidity is among the main driver and it follows that the CDS market is faster in anticipating risks than the bond market not only for corporate but also for sovereign entities. Originality/value – The authors are the first to study the sovereign basis in a sound trading and asset management environment. The paper provides economic explanations and checks for the robustness of the results before the primary issuance of a new government bond. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png The Journal of Risk Finance Emerald Publishing

Managing and trading sovereign risk using credit derivatives and government markets

The Journal of Risk Finance, Volume 14 (5): 15 – Nov 1, 2013

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Publisher
Emerald Publishing
Copyright
Copyright © 2013 Emerald Group Publishing Limited. All rights reserved.
ISSN
1526-5943
DOI
10.1108/JRF-03-2013-0019
Publisher site
See Article on Publisher Site

Abstract

Purpose – The sovereign debt crisis in Europe increased the demand for asset manager worldwide to monitor and manage their sovereign risk. While using information from the credit derivatives and bond markets has been used widely in the corporate sector its usage for sovereign risk is novel. The paper aims to discuss these issues. Design/methodology/approach – The basis between a sovereign credit default swap (CDS) and the government bond contains valuable information for assets managers and traders alike. The paper demonstrates the use of the basis between the announcement date and the issue date of a new government bond to decide whether an investment in this bond is profitable. Findings – With this strategy, the authors are able to generate both over all excess returns with a European sovereign portfolio since 2008 as well as a constant outperformance of simple average euro government bond portfolios. The paper furthermore tests the economic rationale behind this trading strategy and confirms prior findings from the corporate market. CDS market liquidity is among the main driver and it follows that the CDS market is faster in anticipating risks than the bond market not only for corporate but also for sovereign entities. Originality/value – The authors are the first to study the sovereign basis in a sound trading and asset management environment. The paper provides economic explanations and checks for the robustness of the results before the primary issuance of a new government bond.

Journal

The Journal of Risk FinanceEmerald Publishing

Published: Nov 1, 2013

Keywords: Asset management; Credit default swaps; Government bond markets; Sovereign risk

References

  • Corporate bond market transaction costs and transparency
    Edwards, A.K.; Harris, L.E.; Piwowar, M.S.
  • Regression shrinkage and selection via the lasso
    Tibshirani, R.

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