Sovereign debt renegotiation and credit default swaps

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Abstract

A credit default swap (CDS) contract provides insurance against default. This paper incorporates the contract into a sovereign default model and demonstrates that the existence of a CDS market results in lower default probability, higher debt levels, and lower financing costs for the country. Uncertainty over the insurance payout when the debt is renegotiated explains why in the data, as the output declines, the CDS spread becomes lower than the bond spread. Finally, my results show that the 2012 CDS naked ban, that decreased the levels of CDS for European countries, is a welfare reducing policy.

Original languageEnglish (US)
Pages (from-to)50-63
Number of pages14
JournalJournal of Monetary Economics
Volume90
DOIs
StatePublished - Oct 2017

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Keywords

  • Credit default swaps
  • Debt renegotiation
  • Naked ban
  • Negative basis
  • Sovereign default

Cite this

Sovereign debt renegotiation and credit default swaps. / Salomao, Juliana.

In: Journal of Monetary Economics, Vol. 90, 10.2017, p. 50-63.

Research output: Contribution to journalArticle