Badaoui, Saad, Lara Cathcart, Lina El-Jahel, "Do Sovereign Credit Default Swaps Represent a Clean Measure of Sovereign Default Risk? A Factor Model Approach", Journal of Banking & Finance, Vol. 37, No. 7, (July 2013), pp. 2392-2407.
Abstract: In this study, we use a factor model in order to decompose sovereign Credit Default Swaps (CDS) spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present a better decomposition and a more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly driven by liquidity (55.6% of default risk and 44.32% of liquidity) and that sovereign bond spreads are less subject to liquidity frictions and therefore could represent a better proxy for sovereign default risk (73% of default risk and 26.86% of liquidity). Furthermore, our model enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. We find that these risks do have an influence on the default intensity and they contribute significantly to spread movements. Finally, our empirical results advance the idea that the increase in the CDS spreads observed during the crisis period was mainly due to a surge in liquidity rather than to an increase in the default intensity.
Keywords: Sovereign CDS spreads, Default and liquidity intensities, Grid search method and exponential affine models.