International Journal of Empirical Finance and Management Sciences; Vol. 02, No.

03; 2020
ISSN 2706-803X
Intag

The Relationship between Sovereign Credit Default Swaps and Sovereign Bond
Market: Sovereign Crises Context

Author’s Details: (1)Souhir Amri Amamou (2)

Slaheddine Hellara

Received: Jan 20, 2020 Revised: Feb 28, 2020 Accepted: Mar 30, 2020 Online Published: Sep 30, 2020

Abstract
Recent studies suggested that financial markets correlations and volatilities change during crisis periods.
This paper presents a practical framework to test the volatility of sovereign credit default market and
sovereign bond market indexes during the sovereign crisis period. Furthermore, our research tests the
dynamic relationship between the sovereign CDS market evolution and the sovereign bond market, based on
a sample of 10 developed Eurozone countries. Then, we integrate the bond debt's sensitivity presented by its
maturity, which is a line of research supported by previous studies. Our results show that both markets are
sensitive to internal shocks. Moreover, the dynamic relationship between the two markets is more sensitive
to negative information than positive information. Finally, maturity significantly affects the sensitivity of
sovereign bonds to CDS market evolution.
This study contributes to the empirical literature by presenting, to the best of our knowledge, an
unprecedented empirical investigation of the sovereign bond maturity effect's sensitivity to the sovereign
CDS market evolution.
Keywords: Sovereign CDS, maturity effect, ADCC-Garch model
JEL classification: C32; G15; H63
Introduction:

The Credit default swaps(CDS) market presents significant cointegration signals with other markets, such as
the bond market (Blanco et al. (2005); Ericsson et al. (2009); Zhu (2006)). These relationships can explain
changes in correlation relationships between these markets, which can be due to joint movements or a major
event, such as a crisis (Hon et al. (2004)).
In this regard, the interconnection between the CDS market and other markets, whether hedging or debt,
promotes the likelihood of shock transfer. (Kim (2016); Al Qaisi and Batayneh,(2017). Empirically, these
results are supported by the work of D'Errico et al (2017).
This paper proposes an empirical examination of the dynamic relationship between the sovereign CDS
market evolution and the sovereign bond market ranked by maturity, based on a sample of 10 developed
Eurozone countries.
For Olléan-Assouan (2004), sovereign CDSs were born out of the interest of investors for preventive
hedging of country risk. In this regard, Broto and Pérez-Quiros (2015) add that since the subprime crisis, the
sovereign CDS market has experienced great development, a better level of liquidity, and a spectacular
increase in the volume of transactions.
Although this market is qualified by Boone et al (2010) to be a relatively small market compared to that of
bonds, several researchers consider that it perfectly reflects the situation of the sovereign debt market.
Besides, they consider that it is capable of giving signals before a default incident, essentially through
changes in the premium.

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As for the analysis of the relationship between the sovereign CDS market and that of sovereign bonds, the
financial crisis (2007-2008) triggered the appearance of several studies on this subject, in particular those of
Fontana and Scheicher (2016), Carboni (2011), Palladini and Portes (2011) and Arce et al (2013).
Dellate et al (2011) prove that there is a strong relationship between bond spreads and CDS premiums for
the same entities with the same maturities (the same for Hull et al (2004) as well as Lahiani et al (2016)).
This is a causal relationship (according to Giovanni et al (2013)) for the majority of countries heavily
affected by the crisis (Greece, Portugal, and Ireland) Although the significance of the relationships between
the premiums of the two markets is a subject that has been strongly addressed by previous studies and the
results of which show some convergence, the parity of the two premiums is still the subject of contradictory
results.
Some researchers advocate that there is no difference between CDS spreads and those of sovereign bonds. In
this regard, Duffie (1999) and Hull et al (2004) consider that this is a parity relationship between bond
spreads and CDS spreads, in the case of the absence of an arbitrage opportunity.
Contrary, another current study estimates that there are differences between these two premiums. Longstaff
et al (2005) qualify these differences as significant. Zhu(2006)'s empirical findings confirm the theoretical
prediction that bond spreads and CDS spreads move together in the long run. Nevertheless, in the short run,
this relationship does not always hold.
Coudert et Gex(2010) show that the CDS market has a lead over the bond market for corporates. Moreover,
the CDS market's lead has been fuelled by the current crisis. This also holds for sovereigns, although not for
low-yield countries.
With this in mind, several studies treat changes in CDS spreads by associating them with bond spreads
within the framework of a base (CDS-bond) to analyze the simultaneous movements of the two spreads.
Citing as a reference to the work of Blanco et al (2005), Bai and Collin-Dufresne (2013), Nashikkar et al
(2011), and Fontana (2010).
Fontana and Scheicher (2016) associate the change in the base with the financial crisis (2007-2008) in the
first place. They report that this variation worsens with the sovereign crisis. They explain this by the
difference in sensitivity between CDS premiums and bond premiums (in favor of CDS premiums) to the
specificities of the country in terms of credit risk.
Oehmke and Zawadowski (2015) refine the baseline study to analyze transaction volumes in the CDS
market. They consider that there are possibilities for arbitrage between the two markets (CDS and bond) via
grassroots trading that can give rise to the phenomenon of domination between financial markets.
As for the dominant market, Delatte et al (2011) find that the bond market dominates in a calm period while
the CDS market dominates in a crisis. Alexopoulou et al(2009) argue that CDS markets tend to lead
corporate bond markets in terms of price discovery and that this lead-lag relationship strengthened following
the sub-prime related turmoil.
At the same time, several researchers find that the CDS market is the dominant market regardless of the
period studied. For Coudert and Gex (2010), the CDS market is ahead of the bond market even outside the
downward periods (excluding the crisis).
Empirically, following an analysis applied to eight emerging countries, Bowe et al (2009) confirm the
relationship of domination in favor of the CDS market (the same for Ammer and Cai (2011)). This point of
view is supported by Norden and Weber (2009), Blanco et al (2005), Zhu (2006), and Baba and Inada
(2009) who consider that innovations in the CDS market tend to have a greater impact on bond spreads than
the reverse.
Blanco et al (2005) explain this advance by the fact that the risk price discovery process generally takes
place at the level of the CDS market. More recently, following a comparative study between the American

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framework and the European framework, Lahiani et al (2016) manage to consolidate the results of previous
studies regarding the domination of the CDS market in favor of the American market.
Consequently, we note that certain studies have decided on the CDS market's lead on the bond market in
times of crisis (Zhu (2006), Baba and Inada (2009), and Coudert and Gex (2010)). Thus, they confirmed the
non-parity between the spreads of the two markets theoretically proven by several researchers such as Duffie
(1999) and Hull et al (2004).
Based on the results of previous studies, we propose to analyze the sensitivity of the sovereign bond market
to changes in the sovereign CDS market during the period 2010-2016 by applying a DCC-Egarch model.
We choose the framework of the sovereign crisis since the crisis has affected all financial markets especially
markets debt and CDS market. Thus, the detection of the sign of this relationship will be really helpful for
explaining the influence of CDS over financial market stability and their recovery of the public debt by
detecting their impact on its cost (Amri Amamou et Hellara(2016)).
This study contributes to the empirical literature by presenting, to the best of our knowledge, an
unprecedented empirical investigation of the sovereign bond maturity effect's sensitivity to the sovereign
CDS market evolution.
The remainder of the paper is organized as follows. Section 2 presents the empirical analysis. Section 3
describes the empirical results. Finally, section 4 concludes.
2 Empirical analysis
2.1 Univariate Analysis: Estimation of Unconditional Variances of the Sovereign CDS and Sovereign Bond
Market Indices:
• The sample
As presented in Table 1, our work focuses on a sample of 10 developed Eurozone countries (i.e., Germany,
Luxembourg, Austria, Finland, the Netherlands, France, Belgium, Italy, Ireland, and Portugal). At this stage,
the data These data were collected from the official website of the rating agency Standard and Poors
(www.sandpindices.com).
collected are daily, with 1657 observations per data for the period between March 22, 2010, and July 29,
2016.
INSERT TABLE 1
To verify the adaptability of the Garch models to our study framework, a preliminary analysis of the
variables is first conducted to verify the existence of the Arch effect by applying the heteroscedasticity test
to series estimated in first differences All variables were estimated in first difference due to the non-
stationarity at level using the Ordinary least squares (OLS). Table 2 allows the rejection of the null
hypothesis; thus, an Arch effect is observed. We can use models from the Garch family to estimate.
INSERT TABLE 2
 The model choice:
The model choice:
We estimate the various variables in first difference with three models AR (1) - Garch (1.1) considered as an
asymmetric model and the two asymmetric model AR (1) - EGarch (1.1) and AR (1) - GJR-Garch (1.1)i.
Following estimation of the various variables in first difference with three models AR (1) - Garch (1.1)
considered as asymmetrical model and the two asymmetric models AR (1) - EGarch (1.1) and AR (1) - GJR-
Garch (1.1) presented in Table 3, we retained the following EGarch (1.1) model:
-The average equation:
𝐷(𝑋)𝑡 =𝑐1 +𝑐2 𝐷(𝑋)𝑡−1 +𝜀𝑥𝑡 (1)
Where X presents the sovereign CDS index of the Eurozone and the indices of public bonds with different
maturity (ob1, ob2, ... ob6). 𝜀𝑥𝑡 presents the innovations normally distributed.
- The variance equation:

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𝑙𝑛(𝜎𝑥𝑡2 ) =ω+𝛼(𝜙𝜀𝑥𝑡−1 + 𝛾(|𝜀𝑥𝑡−1 | − 𝐸 |𝜀𝑥𝑡−1 |)+𝛽𝑙𝑛𝜎𝑥𝑡−1

2
(2)
INSERT TABLE 3
The results, thus, encouraged us to choose an asymmetric modelii. Since the assumption of normality was
rejected in the case of financial series, the estimation is achieved using the maximum likelihood (ML)
method of Bollerslev and Wooldridge (1992) and the use of the BHHH algorithmiii.
2.2 Bivariate analysis: Estimation and evaluation of the evolution of dynamic conditional correlations
between the sovereign CDS market and the sovereign bond market:
 Variables conception:
We employed at this stage dynamic conditional correlations between the CDS market index and each of the
bond classes presented in Table 4
INSERT TABLE 4
In order to measure these variables, we opted for the application of an asymmetric AR (1) -DCC-Egarch
(1.1) model. This model, developed by Engle (2002), Tse and Tsui (2002), presents an estimate of the CCC
modeliv with the same composition of the covariance matrix. Nonetheless, it proposes a dynamic version of
the correlation matrix. Thus, this model considers that the conditional correlation is dynamic.
Our choice of a multivariate Garch is based on previous studies considering this model category as very
powerful in terms of volatility modeling (Delatte et al. (2011)) It relies on the principle of memory in
correlationsv. Also, recent studies associate these models’ category with the contagion analysis process.
-The average equations:
𝐷(𝑋)𝑡 =𝑐1 +𝑐2 𝐷(𝑋)𝑡−1 +𝜀𝑥𝑡 (3)
𝐷(𝑦)𝑡 =𝑐1 +𝑐2 𝐷(𝑦)𝑡−1 +𝜀𝑦𝑡 (4)
Where X presents the index of sovereign CDS of the Eurozone, it presents the indices of public bonds with
different maturity (ob1, ob2, ... ob6). 𝜀𝑥𝑡 and 𝜀𝑦𝑡 present the innovations normally distributed.
-The variance equations:
𝑙𝑛(𝜎𝑥𝑡2 ) =ω+𝛼(𝜙𝜀𝑥𝑡−1 + 𝛾(|𝜀𝑥𝑡−1 | − 𝐸 |𝜀𝑥𝑡−1 |)+𝛽𝑙𝑛𝜎𝑥𝑡−1 2
(5)
𝑙𝑛(𝜎𝑦𝑡2 ) =ω+𝛼(𝜙𝜀𝑦𝑡−1 + 𝛾(|𝜀𝑦𝑡−1 | − 𝐸 |𝜀𝑦𝑡−1 |)+𝛽𝑙𝑛𝜎𝑦𝑡−1
2
(6)
Table 5, presenting the results of our model’s application, indicates that the models are stable for all the
evaluated pairs. This step is followed by the Heteroscedasticity test of the detected correlations to verify if
those follow an Arch process.
INSERT TABLE 5
The preliminary analysis of the verification of an Arch Effect existence presented in Table 6 indicates the
ability to use Garch family models to achieve our estimates.
INSERT TABLE 6
 Model:
The average equation:
ρ(xy) =𝑐1 +𝑐2 ρ(xy) +𝜀𝑡 (7)
𝑡 𝑡−1

The variance equation:

𝑙𝑛(𝜎ρ(xy) 2 ) =ω+𝛼(𝜙𝜀𝑡−1 + 𝛾(|𝜀𝑡−1 | − 𝐸 |𝜀𝑡−1 |)+𝛽𝑙𝑛𝜎ρ(xy) 2 (8)
𝑡 𝑡−1

3 Empirical results:

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Following the estimation of the unconditional variances of the variables, presented in Table 7, we found that
although the asymmetric effect is significant, the overriding effect during this study period is the
symmetrical effect.
INSERT TABLE 7
As for the α coefficient, it reflects the sensitivity of the indices evolution to a shock affecting their own
markets. This coefficient was positive for all sovereign bonds and sovereign CDS in the Eurozone. It can be
therefore deduced that the indices’ volatility of these two markets is sensitive to events that may affect their
respective markets during the study period.
Noting that the CDS indices and these short and medium-term bonds are the most sensitive to internal shock.
Their indices are, thus, in this case, more volatile than those of long-termed bonds.
We conclude at this level that the longer the bond, the less sensitive it is to shocks affecting its market. In
this case, this category of public bond is perceived as being the safest in the event of a calamity affecting the
market. Clearly, the market participants have confidence in their bonds’ ability to overcome the shock and
do not tend to check their investments, which keep the index level at a lowly volatile level.
At the same time, following the comparison of the two markets’ α coefficients, we deduce that generally the
sovereign CDS market proves to be the most sensitive market for the internal shocks’ realization.
As for the β coefficient, it reflects the recovery time of the market following a shock. This coefficient is
regarded in the literaturevi as a representative of the shocks’ persistence in the market vii. It is the subject of
the stationarity condition of this model. Also, this coefficient is less than 1 for all models tested. Thus, the
stationarity condition is verified for these models.
We also noted that this coefficient has a positive, significant and very high value (greater than 0.9) for all the
variables studied. We can thus indicate that the recovery of the volatility level affecting these markets’
indices following a critical event is very long. As a result, shocks tend to persist in both of the studied
markets during our study period.
As a result, these markets take a lot of time to get rid of the shock effects. This result adheres with the reality
of the Eurozone market since 2010. Noting that the increased risks affecting the zone and propagating from
the riskiest countries to the safest countries make the crisis phase spreads over a rather long period. Until
now, these crisis effects never cease to exist.
As for the coefficient γ, it presents the weight of the information asymmetry in the model. In fact, nonlinear
models like the asymmetric univariate Garch process allow a better estimate of changes in the volatility of
the assets (Bensafta and Samedo, 2013). This finding supports those of Brock and al (2009) stating that
interactions between markets or assets are usually linked to nonlinear systems, hence the addition of these
models to our study.
This contribution is emphasized with the general framework of the crisis period studied in our research. In
fact, as presented by the literature, e.g., Hsiao and Morley (2015) who prove that we are witnessing non-
linear relationships between markets in times of crisis.
In our case, the coefficient γ is negative and significant for the majority of the variables (except CDS and
Bond 6). We can conclude that the two markets indices are sensitive to the signs of the information received,
indicating that the good news spreading in these markets generates less volatility than the bad news.
Stakeholders in the bond market are therefore more sensitive to negative shocks than to positive ones. This
sensitivity is significant for all bond classes, except for bonds of over 10 years old and sovereign bonds.
This result goes in line with the literature. In fact, Engle and Ng (1993) argue that one cannot behave in the
same way when receiving negative and positive information, since negative information is more associated
with brutal and common reactions of the market’s participants. Therefore, they can present a source of
panic.
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In opposition, the sovereign CDS market and the long-term bond market behave in a less volatile manner
following a negative shock. These markets benefit from these shocks, which can be explained by these
markets’ nature, offering investors a haven in a shock context.
Following the estimation of the dynamic correlations evolutions, the results of which are illustrated in Table
8, we can notice that the dominant effect during this period of study is the symmetric effect, although the
asymmetric effect is significant.
INSERT TABLE 8
We note that the α coefficient is positive for all of the correlations between sovereign bonds and sovereign
CDS in the Eurozone (except for bond 1, 2 and 5). This sign indicates that the volatility of these correlations
is sensitive to events that may affect their respective markets during the study period. This sensitivity is
much greater for the dynamic correlation between government bonds of over 10 years old and the sovereign
CDS index.
In addition, we noted that the dynamic correlations between the two markets are significantly sensitive to
shocks, whatever is the maturity of the bond (except ob3,) to internal shocks. As a result, the level of
correlation between the two markets changes significantly following a shock that can be a source of
contagion. This finding adheres with the literature indicating that a significant change in correlations
between two markets may be a symptom of contagion (Dornbush et al., 2000; Bae et al., 2003; Longstaff,
2010).
As for the β coefficient, it has a positive and significant value for all the correlations, except the one linking
the ob5 and the CDS. The negativity of this correlation has not affected the significance of our results since,
unlike the Arch and Garch process, this model does not require a positivity of the coefficients as they are
expressed in log (Ali, 2013).
We can thus consider that the recovery of the volatility level affecting these markets following a critical
event is long.
We also note that the γ coefficient is negative and significant for the correlations between CDS and the
bonds 1,3 and 4, which indicates that the good news spread in these markets generates less volatility of the
correlations between the two markets than the bad ones. The dynamic relationship between the two markets
is therefore more sensitive to negative shocks than to positive ones.
4 Conclusions
We started this analysis by detecting unconditional variances in indices related to the sovereign bond market
as well as to the sovereign CDS market. The use of the EGarch model (asymmetric model) has helped to
highlight the general sensitivity of both markets to negative information.
Likewise, we have found that the sovereign CDS market is the market most sensitive to internal shocks. For
their part, short- and medium-term sovereign bonds are the most vulnerable bond classes to internal shocks.
At the same time, we concluded that both markets exhibit a high degree of persistence in the face of shocks.
Subsequently, we carried out an assessment of the conditional variance and therefore of the dynamic
developments between sovereign CDSs and each of the bond classes. We have found, at this level, that the
relationship between the sovereign CDS market and the longest sovereign bond class is the most sensitive to
internal shocks.
Likewise, generally, the dynamic relationship between the two markets is more sensitive to negative
information than to positive information.

i
We posted at this level to choose between autoregressive models of order 1 AR (1), since this is usually the
most appropriate order for financial time series. Similarly, the choice of the coefficient p and q equal to 1 is

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often considered to be the most appropriate in the case of volatility evaluation and modeling associated with
the existence of an Arch effect on financial series (Bollerslev et al (1994)).
ii
This models’ typology answers to a size difficulty affecting the univariate Garch models, such as the Garch
model (1,1), which is the non-consideration of the impact of negative information sign.
iii
It is presented by Berndt et al. [1974] and adopted to nonlinear maximizations by Engle and Kroner (1995)
iv
This model, developed by Bollerslev (1990), considers covariance as a composition of variance and
correlation. The latter persists throughout the study period, which is unrealistic and very simplistic and this
with reference to Koutmos and Booth [1995] and Booth et al. (1997).
Several studies have used this class of models to estimate volatility. While others consider this choice lacks
empirical and theoretical justification, namely, King and Wadhawani (1990), Tse and Tsui (2002), Cappiello
et al. (2006).
v
This principle has been widely studied by research, e.g., Ding, Granger and Engle (1993).
vi
See: Ali et al. (2013)
vii
Bensafta and Semedo (2011) consider that the persistence of volatility shocks leads to the aggregation of
empirical volatilities and distributions with thick tails.
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