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OP 78. Lóránt Varga: The information content of Hungarian sovereign CDS spreads

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In our paper we present how the Hungarian credit default swap (CDS) market functions, and indicate its position in the global credit derivatives markets. Our primary goals are to glean some information from the CDS spreads about Hungary’s credit risk, and to determine the role of the Hungarian sovereign CDS market in different market periods, as well as its long-term relationship with other Hungarian financial markets. Our findings suggest that the Hungarian market has low liquidity compared to the average liquidity of credit derivatives markets. However, relative to the outstanding stock of Hungarian sovereign foreign currency bonds, the daily average turnover of the market and the outstanding stock of Hungarian sovereign CDS contracts at the end of 2007 were substantial, estimated to be around EUR 10-20 million and EUR 7-20 billion respectively. Even though the Hungarian sovereign CDS spread and foreign currency bond credit spread tend to move in tandem in the long run, the two rates may temporarily deviate from one another due to micro structural factors. Hungary’s credit risk premium is primarily defined in the Hungarian sovereign CDS market, which means that any new information pertaining to Hungary’s credit risk is captured in the CDS spreads first. In contrast, the Hungarian foreign currency bond market is not an effective market, given that foreign currency bond credit spreads merely adjust to the changes of CDS spreads afterwards. During particularly turbulent market periods Hungarian sovereign CDS spreads tend to rise higher than is fundamentally justified.

JEL: F34, G12, G14, G15.

Keywords: credit derivatives markets, credit default swap, sovereign foreign currency bond markets, sovereign credit risk, credit rating, price discovery.

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