The Link between Eurozone Sovereign Debt and CDS Prices

We perform a theoretical and empirical analysis of the relationship between the price of Eurozone sovereign-linked credit default swaps (CDS) and the same sovereign bond markets during the Eurozone debt crisis of 2009-2011. We first present a simple model which establishes the no-arbitrage relationship between CDS and bond yield spreads. We then test this relationship empirically and explain why the market may deviate from it. This includes the different currencies of denomination of market-standard CDS and their deliverable obligations. We also examine whether changes in CDS spreads cause changes in bond spreads, and vice-versa, in a Granger sense. The hypothesis of cointegration between CDS and bond spreads for most Eurozone sovereigns is rejected and we suggest that this may be due to the currency effect. We do find evidence for a Granger causal relationship with a one day lag from CDS to bonds for Greece and Spain, the reverse relationship for France and Italy and a feedback relationship for Ireland and Portugal.