CDS Pricing and Elections in Emerging Markets

Abstract

To study the role of elections in financial market instability, we focus on the role of credit risk pricing during elections from 2004 to 2007 in 13 emerging market economies. We use a unique dataset of daily credit default swap (CDS) pricing, with standard macroeconomic controls, to study the role of elections in prompting financial market instability and contagion. Sovereign CDS pricing provides a number of advantages in understanding emerging market instability of previous studies. First, the daily data allows a greater level of specificity than was used in previous credit market and political studies. Second, even though sovereign credit conditions change slowly, CDS pricing changes daily, reflecting sentiment or forward-looking beliefs. Third, the CDS allows us to focus on the perceived public credit risk of an election and the incoming government. Our study reveals a number of unique findings. First, investors price in additional risk for elections regardless of party, incumbency or size of win. Second, long- and short-term investors price risk very differently, with 1-year CDS investors reacting much more strongly to election risk, causing the overall spread between 10- and 1-year swaps to narrow. Third, our results provide continued support for the theory of investor herding in international financial markets, and a focus on a small number of economic variables in determining sovereign creditworthiness. Investors do not study the relative risk factors as much as price in structural risk by the existence of definable benchmarks like elections.

The Economic Impact of Corruption Scandals in Latin America: Evidence from the Sovereign Bond Market

“…Spread changes rely less on political variables and fundamentals, and more on market sentiment (Eichengreen and Mody 1998). Balding (2011) and Özatay et al (2009) point to the effect of herding behavior on emerging countries' sovereign bonds market and find substantial contagion effects. Yield inflation of one emerging economy influences neighbouring countries, even when neighbours do not suffer any negative changes in economic outlooks.…”

Political credit cycles

“…Thus, the fear of losing an important source of external funding may suppress temptations to generate electoral credit cycles. In particular, governments that rely on international bond markets for financing may face an even weaker temptation for credit market manipulation (Balding, 2011; Kaplan, 2013).…”

“…Sobel (2002) and Mosley (2003) find the threat of exit by mobile asset holders is more credible in developing countries, where sovereign default risk is higher. Compared to developed economies, domestic credit in developing countries is also more sensitive to international capital inflows and should constrain policy‐makers’ ability to impact lending dynamics (Balding, 2011; Campello, 2013; Kaplan, 2013). Accordingly, we expect to see the mediating effects of financial openness to be stronger in developing compared to developed economies.…”

İktisadi, Finansal ve Politik Risklerin Türkiye CDS Primine Etkileri

“…They found that while an increase in public debt increased the CDS premium, the most effective variable on CDS was unemployment and the least effective variable was inflation. Balding (2011) examined the relationship between CDS pricing and elections in 13 emerging market economies for the period 2004-2007 and found that elections had statistically significant effect On CDS pricing. Longstaff, Pan, Pedersen & Singleton (2011) investigated the nature of CDS by examining the relationship between CDS spreads of 26 countries and country-specific factors of those countries and the relationship between CDS spreads and global financial variables.…”