Three Essays on Pricing and the Price Discovery Process of Sovereign Credit Default Swaps

In the first essay, author undertakes a comprehensive study of eight emerging sovereign entities in order to determine the nature of long-run dynamic interaction between two highly related financial markets on which same, respective, sovereign credit/ default risk is traded. Thus, eight pairs of individual sovereign credit risk prices are independently analyzed using daily time series data during the time period 2006-2016 to determine which market more quickly impounds new information in efficiently pricing the credit risk. These related markets are sovereign credit default swap (CDS) and bond markets. Country level analysis suggests that prices in both markets move in tandem with each other and the sovereign CDS market dominates the price discovery process during tranquil periods, contributing more than 70% to the overall price discovery process, a finding attributed to its greater relative liquidity. However, during the crisis, a common stochastic trend is missing between CDS and bond spreads, suggesting that during times of extreme distress, these markets price credit risk differently. These results have implications for emerging market investors and asset managers who engage in arbitrage between the two markets as well as financial stakeholders who monitor sovereign credit spreads to gauge the level of political and/or default risk in emerging markets. The second and third essays are closely related as they attempt to establish the notion that socioeconomic variables are key predictors of sovereign CDS prices. Existing literature focuses overwhelmingly on global financial and country specific macroeconomic variables as determinants of CDS spread. Using the data from 66 countries over the period of 2007-2015, significant support is reported for the hypothesis in the second essay that state fragility, a socioeconomic construct borrowed from foreign policy literature, positively affects the CDS pricing. This support is robust across different regression models with varying specifications. Two way fixed effect model reports that after controlling for global and country specific macroeconomic variables a 1% increase in state fragility, ceteris paribus, causes an increase in CDS premium by 1.60%. Using the data from 2015 for 52 countries, essay three reports that one percentage point increase in social capital of a country causes credit derivative prices to decrease by 1.19%