DP9092 | Animal Spirits in the Euro Area Sovereign CDS Market

Publication Date

19/08/2012

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Abstract

We study the determinants for the sovereign credit default swap (CDS) spreads of five Euro-area countries (Greece, Ireland, Italy, Portugal, Spain) in the post-Lehman-Brothers period. We find that there are regime switches in the process of sovereign CDS spread changes. We consider three alternative empirical hypotheses associated with regime switches. Under the first hypothesis, there are rational sunspot equilibria. Under the second hypothesis, there is a unique fundamental equilibrium and the regime switching is caused by changes in policy makers' preferences. The third hypothesis relaxes the rational expectations assumption. Under this hypothesis, indicators of the market fundamentals are not always precise. They are better indicators if cognitive biases are small and the rational expectations economy is a good approximation for reality. However, if market uncertainties enlarge the cognitive biases, the market-based indicators of fundamentals are no longer precise. In this case, they are not useful for CDS pricing. We find that the first two hypotheses are difficult to fit the data and the third hypothesis provides a good explanation for the sovereign CDS spread dynamics in our sample.