THE RELATIONSHIP BETWEEN THE SOVEREIGN BOND AND CDS MARKETS AFTER THE ONSET OF THE EUROPEAN DEBT CRISIS

As a consequence of the financial crisis, the euro area public finances deteriorated significantly, causing the sovereign debt crisis. Since the traditional monetary policy was found to be powerless, the European Central Bank (ECB) was forced to rely on unconventional monetary policy. During the debt crisis, the bond yields increased considerably while also the volume of sovereign credit default swaps (CDS) increased substantially. Consequently, the CDS markets were seen to play a significant role in the decay of public finances. As a result, the EU set a ban on uncovered CDS contracts. In theory, the bond and CDS spreads should reflect the credit risk of a reference entity equally meaning that the difference between the spreads of these two credit risk instruments should be approximately zero in a long-run. This thesis addresses to a previously unexamined period from 2009 to 2018 in order to examine the effects of the unconventional monetary policy and the CDS regulation to the long-run equilibrium relationship and the price discovery process between the euro area sovereign bond and CDS markets. This thesis contributes to the previous studies by examining the long-run equilibrium by recently developed autoregressive distributed lag (ARDL) bounds test. The information transmission between the bond and CDS spreads is examined by vector error correction model (VECM) and Granger causality test. The data of the study consists of 5-year bond and CDS spreads for ten euro area sovereigns. The long-run equilibrium relationship and the price discovery process is found to be more mixed and country-specific than previous studies suggest. The CDS market leads the price discovery process in 70% of the countries during the full sample period. Furthermore, the adoption of the uncovered CDS ban in 2012 is detected to have a clear impact on the price discovery process as it moves strongly on the bond market. Moreover, as a result of the implementation of the ECB’s expanded asset purchase programme (APP) in 2015, the price discovery process was shifted toward the CDS market despite the fact that the volume of the euro area sovereign CDS contracts was rather petit. Hence, even an inactive derivative market seems to be able to transmit new information faster and, thus act as the primary information conveyer between these two credit risk markets.fi=Opinnäytetyö kokotekstinä PDF-muodossa.|en=Thesis fulltext in PDF format.|sv=Lärdomsprov tillgängligt som fulltext i PDF-format