Price Formation on the CDS Market: Lessons of the Sovereign Debt Crisis (2010-)-continued

February 29, 2012--ABSTRACT
Further to recent trends in CDS prices and sovereign bond yields, this memo looks into the subject of price formation on CDS markets, notably on sovereign issuers. Interviews were conducted on this subject with operators on these markets.
Operators agreed that for Germany and the United States, recent CDS market trends have had no impact on the financing costs of these States. This matches the findings of academic research which has not yet established a causal link between the CDS prices and bond yields of the best-rated sovereign issuers. The sovereign CDS market is still lacking in depth compared with bond markets, arbitrage possibilities are costly and risky and the operators are not necessarily the same on the two markets. The analyses that have been conducted, especially over the recent period, confirm that neither the CDS nor the bond market can be shown to lead the other. They also show that as long as spread levels remain low, correlations between CDS market and bond market are weak: as long as default risks seem to be contained, bonds play their role as a refuge. However, when sovereign risk rises sharply and spreads reach a certain level, bonds lose their refuge function and a correlation appears. France would seem to have been in such a situation since autumn 2011.

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Source: AMF Autorité des marchés financiers

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