TAF PUBLISHING

This study analyzes the price discovery process of credit risk in sovereign Credit Default Swap (CDS) and bond markets of peripheral and core European countries. We consider an extensive time sample that begins with the transformation of the global financial crisis to a debt crisis in Eurozone and ends shortly before the outburst of COVID-19 pandemic crisis. To investigate the relative efficiency between CDS and bond market in credit risk pricing, we apply co-integration and Granger causality methods utilizing rolling windows. We obtain dynamic price discovery measures which allow us to identify the leading market in price discovery in a time-varying context and, thus, to detect potential alternations in the direction of influence from CDS to bond market and vice versa. Indeed, we find that the dominant market in terms of pricing and informational efficiency depends on the examined period, while CDS market leadership is more frequently observed during periods of increased risk and economic uncertainty. To examine the determinants of the leading market in price discovery, we estimate a Log it regression model using a set of economic variables as explanatory factors. The empirical results reveal that the funding cost and the level of systemic risk in financial markets positively affects the probability of CDS market leadership. The level of volatility in stock markets negatively affects the pricing efficiency of the CDS market in core European countries, while its effect is insignificant in peripheral countries. Relative liquidity between CDS and bond market and counter party risk also have significant effect on the determination of the leading market. However, the sign of the effect depends on the country concerned. Overall, the conclusions of this study provide useful insights for investment, funding, and regulation decisions to participants in sovereign credit risk market.