A View from Outside : Sovereign CDS Volatility as an Indicator of Economic Uncertainty

This paper proposes the volatility of sovereign credit default swaps (CDS) as a measurement of economic uncertainty. Sovereign CDS provide protection against losses from sovereign defaults and are traded for almost all countries by the world’s largest financial institutions. The premium for protection, the so-called CDS spread, depends on a country’s economic and political conditions and provides an outside view of global financial institutions. The empirical results show that the volatility of sovereign CDS spreads contains information about economic uncertainty. For a broad panel of 16 countries we find that sovereign CDS volatility shares directional information with popular news-based economic policy uncertainty (EPU) indices. Using Bayesian panel vector autoregressions, we also find similar responses of output and unemployment to shocks in CDS volatility, equity volatility, and EPU. Sovereign CDS volatility can therefore be used either as an additional indicator of uncertainty or as a general indicator of economic uncertainty when EPU indices are not available or other indicators are considered unreliable