US macroeconomic surprises and the emerging‐market sovereign CDS market

• Published date: 01 March 2023
• Author: Junmao Chiu,Wei‐Che Tsai,Chi Yin
• Date: 01 March 2023
• DOI: http://doi.org/10.1111/eufm.12363

DOI: 10.1111/eufm.12363

ORIGINAL ARTICLE

US macroeconomic surprises and the

emerging‐market sovereign CDS market

Junmao Chiu |Wei‐Che Tsai |Chi Yin

Department of Finance, National Sun

Yat‐sen University, Kaohsiung, Taiwan

Correspondence

Chi Yin, Department of Finance,

National Sun Yat‐sen University, 70

Lien‐Hai Rd, 80424 Kaohsiung, Taiwan.

Email: d064030001@student.nsysu.

edu.tw

Abstract

Our primary aim is to examine whether US macro-

economic surprises affect the slope of the term structure

of ‘sovereign credit default swap’(SCDS) spreads in

emerging markets. Our empirical results show that

positive (negative) US macroeconomic surprises are

likely to reduce (increase) the term structure slope of

SCDS spreads in emerging countries. We find that the

slope values in emerging markets are positively related to

future market returns over 1‐and 2‐day horizons. Our

results provide general support for the future informa-

tional role played by SCDS spreads for the national stock

market within emerging markets.

KEYWORDS

emerging markets, sovereign credit default swaps, spillover

effects

JEL CLASSIFICATION

F30, G15

Eur Financ Manag. 2023;29:549–587. wileyonlinelibrary.com/journal/eufm © 2022 John Wiley & Sons Ltd.

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We would like to thank John A. Doukas (the editor) and two anonymous referees for constructive and insightful

comments that helped us significantly improve our paper. We also appreciate helpful comments and suggestions from

Joshua Aizenman (University of Southern California), Yenn‐Ru Chen (National Chengchi Univeristy), Robin K. Chou

(President of the Asian Finance Association), Ting‐Kai Chou (National Cheng Kung University), Huimin Chung

(National Yang Ming Chiao Tung University), Kewei Hou (Ohio State University), Jun‐Koo Kang (Nanyang

Technological University), Carl Shen (Macquarie University), Yung‐Ming Shiu (National Chengchi University), Jeffrey

Wang (UNSW Sydney), Yanzhi (Andrew) Wang (National Taiwan University), Jimmy Yang (Oregon State University),

Jason J. H. Yeh (The Chinese University of Hong Kong) and Min‐Teh Yu (Providence University). We want to also

thank the participants of the Conference on the Theories and Practices of Securities and Financial Markets (SFM), the

2019 Asian Finance Association Conference, the 2020 Conference on Taiwan Economic Research, the 2020 TRIA

International Conference on Risk and Insurance & Annual Meeting and the seminar participants at Beijing Normal

University and Harbin Institute of Technology for their helpful comments. We also gratefully acknowledge the funding

provided by the Ministry of Science and Technology.

1|INTRODUCTION

The various financial crises that have occurred in the past two decades—the technology bubble

of 2000, the subprime mortgage crisis of 2008 and the COVID‐19 crisis—have resulted in

financial markets becoming more volatile with severe effects on both regulators and investors

alike. Thus, there has been rapidly growing interest on hedging against risk. In particular,

serious sovereign risks associated with high levels of market uncertainty have occurred such as

the Eurozone sovereign debt crisis, the UK's withdrawal from the European Union (EU) and

the China–US trade war that have led to a boom in the markets for ‘sovereign credit default

swaps’(hereafter SCDS).

1

SCDS has become an important tool in the management of credit risk. The sell side of

SCDSs provides protection against default losses when the reference entity cannot afford to

repay the interest or the principal. SCDS buyers periodically pay premiums—calculated as the

SCDS spread multiplied by the notional amount—to receive protection during the contract

period. Based on the above characteristics, the SCDS is a suitable derivative for gauging the

possibility of upcoming market deterioration. According to the Depository Trust and Clearing

Corporation, the gross notional amount of outstanding SCDSs was roughly US $2.2 trillion at

the end of May 2010 and subsequently reached US $3.0 trillion in June 2012. The SCDS market

has shown stable growth since the gross national amount of outstanding SCDS reached US $1.7

trillion in July 2017.

Our goal is to investigate whether any relevant information is embedded in the SCDS spread

curve and whether the SCDS provides country‐specific information that influences the returns

of a stock index. Because the SCDS spread quotes have varying times to maturity, this study

focuses on the term structures of the SCDS spreads (hereafter SCDS spread slopes). The recent

literature has not only emphasized SCDS spreads but also the shape of the term structure of

those spreads. Pan and Singleton (2008) show that the SCDS spread slopes contain information

on both the arrival rates of credit events and the loss rates of given credit events, while

Augustin (2018) subsequently demonstrates that the SCDS spread slopes contain information

on cross‐sectional differences in domestic risks.

While studies have focused on the within border effect on sovereign default risk, they have

paid little attention to the cross‐border effects on that risk. For example, Chiarella et al. (2015)

find that SCDS spreads are determined by country‐specific fundamentals. H.‐Y. Chen and Chen

(2018) find that the higher the quality of country governance, then the more willing are

countries to repay their debt which thus reduces default probabilities. Jeanneret (2018) has

discovered that governments that struggle to raise fiscal revenues and that use these funds to

service their debts experience a higher probability of sovereign default risk. Thus, we argue that

whether cross‐border effects play a significant role in explaining SCDS spreads is worth

discovering and will add more related evidence to the literature in this paper.

Among all the cross‐border effects, Flannery and Protopapadakis (2002) argue that

macroeconomic variables are an ideal proxy for extra market risk factors, because

macroeconomic changes have simultaneous effects on multiple firms’cash flows and may

influence the risk‐adjusted discount rate. Patro et al. (2002) demonstrate that macroeconomic

variables significantly contribute to the risk exposure using a sample of 16 OECD (Organisation

1

A SCDS is a type of credit derivative that is created between two counterparties providing risk management for buyers

against any sovereign debt losses arising from sovereign credit events, such as default or debt restructuring.

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CHIU ET AL.

for Economic Co‐operation and Development) countries. Hausman and Wongswan (2011) have

discovered that US monetary policy announcements have prominent effects on foreign equity

indexes, short‐and long‐term interest rates and exchange rates in 49 countries. Aizenman et al.

(2013) demonstrate that certain macroeconomic factors are important determinants of SCDS

spreads. On top of that, Kurov et al. (2019) have discovered appealing and persuasive evidence

of informed trading before several important macroeconomic news announcements that prove

these announcements indeed move financial markets. Cathcart et al. (2020) further posit that

news could be of more of an exogenous information nature and is ex ante to the market

reaction. All the above evidence shows that macroeconomic variables are an excellent

candidate for examining their impact on both micro‐and macro‐aspects of financial markets.

This paper aims to complement these other studies by providing comprehensive evidence

regarding the cross‐border effect of macroeconomic news on sovereign default risk. We

contribute to the SCDS literature by exploring whether US macroeconomic surprises affect the

slopes of SCDS spreads in emerging markets. Our analysis uses a sample with a total of 19

emerging countries: seven in the Asia‐Pacific (APAC) region; five in the Americas (AMER);

and a total of seven in Europe, the Middle East and Africa (EMEA). The sample covers the

period from 2008 to 2020. Our research is driven by a specific strand in the literature that

demonstrates that the macroeconomic announcements of the world's major economies affect

not only their domestic financial markets but also the financial markets of other nations,

particularly if those nations are in emerging markets.

2

Furthermore, global integration can cause uncertainties for major economies that have

spillover effects on emerging economies. As argued by Longstaff et al. (2011) and Dieckmann

and Plank (2012), there are commonalities between SCDS spreads and the influence of

common global risk factors that relate to economic performance in the United States. Harju and

Hussain (2011) have also stated that US macroeconomic news has cross‐border effects while

Caselli et al. (2016) have shown SCDS spreads give an informational advantage to the financial

community. Hence, we naturally consider whether there are spillover effects from US

macroeconomic surprises on SCDS pricing within emerging markets. To enhance our

understanding of such effects, we further examine the effects of the informational content in

the slopes of SCDS spreads on the future returns of the market index.

We first consider up to nine types of US macroeconomic indicators: the unemployment rate,

retail sales, building permits, consumer confidence, personal spending, the purchasing

managers' index, gross domestic product (GDP) advance, leading indicators and durable orders.

We have collected the data that are used to measure the forecast values of prescheduled

macroeconomic announcements and actual announcement values from Thomson Reuters

Datastream. We have followed the approach of Kim et al. (2015) to categorize macroeconomic

surprises as exogenous variables of good or bad news and then specified an ‘exponential

generalized autoregressive conditional heteroscedastic’(EGARCH) model to determine

whether the good or bad news announcements influence the slopes of the SCDS spreads in

emerging markets. Our empirical results show that good (bad) surprises from US

macroeconomic news announcements reduce (increase) the level of and variance in the slopes

of the SCDS spreads that thereby providing support for the argument that macroeconomic news

surprises have spillover effects on the term structures of SCDS spreads in emerging markets.

2

Examples include Beckeret al. (1995), Bekaert and Harvey (1997), Nikkinen and Sahlström (2001), Hanousek et al.

(2009) and Hayo et al. (2010).

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