The market for insurance against the default of safe sovereigns as Germany, Japan, or the United States is large and the insurance premiums are substantial, even though debt issued by these countries are arguably the safest and most liquid financial assets.
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What are the motives behind purchasing insurance against the default of safe sovereigns? Are high CDS premiums truly reflecting the risk of default, when a default of one of these sovereigns would likely trigger a series of defaults in the banking sector, making it unlikely that Investors would receive compensation?
In “Safe Haven CDS Premiums”, Sven Klingler from BI Norwegian Business School and David Lando from Copenhagen Business School investigate these questions by analyzing data on credit default swaps. “Credit Default Swap” (CDS) is a contract in which one party makes quarterly premium payments to a second party who, in return, agrees to compensate the first party if the underlying entity defaults.
“If you buy insurance against the default of the U.S. from, say, Goldman Sachs, do you really expect a payoff in a scenario where the U.S. defaults? We thought that there must be another reason for the large volumes,” says Sven Klingler, Assistant Professor at the Institute for finance at BI Norwegian Business School.
The authors argue that financial regulation gives derivatives-dealing banks an incentive to purchase sovereign CDS. More precisely, the financial regulatory regime of Basel III introduces a capital charge against uncollateralized over-the-counter (OTC) derivatives, even if the counter-party is a safe sovereign, giving derivatives-dealing banks a choice between facing an addition to regulatory capital or purchasing CDS.
“The idea is as follows; banks have large derivatives positions with countries and countries typically do not post collateral in these derivatives. The new financial regulation is somewhat paradox — holding government bonds issued by these countries does add a capital charge. We argue that it is cheaper for banks to use CDS hedging instead of facing the capital charges, “says Klingler.
The authors incorporate the tradeoff between facing a capital charge or purchasing CDS protection in an equilibrium model where a derivatives-dealing bank demands CDS to free regulatory capital. Due to a lack of natural CDS sellers, an end-user of derivatives provides the CDS to the bank.
Because selling CDS is costly for end users, due to an associated margin requirement, the end user demands a positive CDS premium, even for a risk-free sovereign. The model leads to an equilibrium CDS premium that depends on the demand for freeing regulatory capital by banks and the opportunity cost of selling CDS. The CDS premium is elevated because of regulatory frictions.
Based on their theory, the authors conduct an empirical analysis of the CDS market and first document that derivatives dealers are net buyers of sovereign CDS, as opposed to being net sellers of CDS, which is common in most other markets. In line with their hypotheses, the authors find a strong link between the amount of sovereign CDS outstanding and the outstanding OTC derivatives in the sovereigns, as well as a link between sovereign CDS premiums and proxies for regulatory hedging demand.
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