The consistency of credit risk pricing in emerging market sovereign debt: the relationship between Bond prices and credit default swap spreads
Theoretical foundations indicate that, under no-arbitrage conditions, a relationship between bond prices and Credit Default Swap prices should be observed. This study examines whether this relationship is evident in emerging market sovereign debt. By performing Johansen cointegration analysis on the debt spread and the CDS premium, mixed evidence is found: a relationship exists in some time periods but not in others. This implies inconsistent pricing of credit risk in some periods and is in line with previous empirical studies. Therefore, there exist opportunities for credit risk arbitrage although profits from these opportunities may be restricted by the limits to arbitrage. In addition, the effect of bond market volatility on the relationship between the debt spread and the CDS premium in analysed. It is found that volatility due to idiosyncratic factors does not affect the existence of the relationship. Finally, a qualitative analysis of the behaviour of credit risk in light of economic and political conditions provides some insights for macroeconomic policy makers in emerging market economies. Potential extensions to this study include empirical analysis on a different sample of sovereign emerging market securities and extension of existing credit risk pricing models.