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Managing and trading sovereign risk using credit derivatives and government markets

Samuel Pollege (University of Ulm, Institute of Finance, Ulm, Germany)
Peter N. Posch (University of Ulm, Institute of Finance, Ulm, Germany)

Journal of Risk Finance

ISSN: 1526-5943

Article publication date: 4 November 2013

1637

Abstract

Purpose

The sovereign debt crisis in Europe increased the demand for asset manager worldwide to monitor and manage their sovereign risk. While using information from the credit derivatives and bond markets has been used widely in the corporate sector its usage for sovereign risk is novel. The paper aims to discuss these issues.

Design/methodology/approach

The basis between a sovereign credit default swap (CDS) and the government bond contains valuable information for assets managers and traders alike. The paper demonstrates the use of the basis between the announcement date and the issue date of a new government bond to decide whether an investment in this bond is profitable.

Findings

With this strategy, the authors are able to generate both over all excess returns with a European sovereign portfolio since 2008 as well as a constant outperformance of simple average euro government bond portfolios. The paper furthermore tests the economic rationale behind this trading strategy and confirms prior findings from the corporate market. CDS market liquidity is among the main driver and it follows that the CDS market is faster in anticipating risks than the bond market not only for corporate but also for sovereign entities.

Originality/value

The authors are the first to study the sovereign basis in a sound trading and asset management environment. The paper provides economic explanations and checks for the robustness of the results before the primary issuance of a new government bond.

Keywords

Acknowledgements

JEL classification – G11, G32, H63

Citation

Pollege, S. and N. Posch, P. (2013), "Managing and trading sovereign risk using credit derivatives and government markets", Journal of Risk Finance, Vol. 14 No. 5, pp. 453-467. https://doi.org/10.1108/JRF-03-2013-0019

Publisher

:

Emerald Group Publishing Limited

Copyright © 2013, Emerald Group Publishing Limited

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