The study is organized as follows. Section 2 briefly discusses the market for credit default
swaps and establishes a theoretical basis for relationship between CDS premiums, equity prices and
currency trends. Section 3 summarizes the literature on financial crises prediction. Section 4 presents
the model specification and the definition of crises. Section 5 describes the panel data. Section 6
presents the results and Section 7 offers concluding remarks.
2.Theoritical Framework
The credit default swap (CDS) market is the largest market of credit derivatives. In a CDS
transaction, the protection buyer pays a series of fixed periodic payments (CDS premium) to the
protection seller in exchange for a contingent payment in case of a credit event, such as bankruptcy,
credit downgrade or a failure to make the scheduled payments. Duffie (1999) explains that the CDS
premium is equivalent to swapping the payments from a risky security for the payments of a risk-free
security in exchange of a contingent payment in case the risky security defaults. Hence, the premium
reflects the credit risk of the underlying asset and is normally quoted in basis points over a reference
rate, supposed to be a risk-free rate.
CDSs are actively traded on corporate bonds and sovereign debt. This paper focuses on
emerging markets where most contracts reference sovereign obligations. Sovereign CDSs are
considered to be the most liquid credit derivative instruments in emerging markets. The usual contract
is written on notional amounts of $10 million with a five-year maturity. For instance, a 5 year CDS
rate of 200 for a Bulgarian international bond means that it costs $200 per annum to insure a $10,000
face value Bulgarian international bond.
Players in the emerging market CDSs use the contracts for a number of reasons. CDSs allow
speculation on the future creditworthiness of countries. Also, they allow exploitation of arbitrage
opportunities that may arise from the spread between CDS and the referenced bond. In addition, CDSs
are used to manage the exposure to sovereign bonds. Participants in the market utilizing these
opportunities range from hedge funds, mutual funds, banks to pension funds. Because of the players
involved and the theory that follows, we assume that CDS premium reflects future expectations of the
investors and the premium can be used to predict outcomes in currency and equity markets in
emerging countries.
First, we discuss our theoretical basis for the effect of the changes in CDS premium on the
probability of a currency crisis in the emerging markets. Let N be the notional amount of a contract, s
be the CDS rate (premium) and p be the default probability of bond payments. Seeker of protection
against default will buy the contract if the present value of premium payments will be equal or less
than the present value of the expected loss from default:
Ns(1 - p ≤ Np(1 - R)
(1)
1+r 1+r
where R is the recovery rate in case of default and r is the interest rate. The above equation produces
an expected default probability, set by investors, that is proportional to the premium paid:
s
(2)
P ≤------
s+1-R
where 1 - R falls into [0,1]. According to Eq. (2), an increase in the CDS premium (s) at a fixed R,
indicates an increased default probability on bond payments of the reference entity (p).
In cases where the reference entity is sovereign debt, the increased default concern translates
into a tendency of the currency to depreciate, as concluded by Cochrane (2004). The argument comes
from fiscal theory and the theory of optimal distorting taxation. Chochrane uses the analogy of money
as a stock in fiscal theory to establish a relation between currency devaluations and fiscal balances.
From the theory of optimal distorting taxation, Chochrane argues that a currency crash represents a
choice by the government to devalue outstanding nominal debt rather than increase distortionary
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