Default Risk of Advanced Economies : An Empirical Analysis of Credit Default Swaps during the Financial Crisis

What determines the price of insurance against default of advanced economies? Our laboratory to answer this question is the credit default swap (CDS) market on government debt of 18 advanced economies. The price of credit protection on these countries shows a strong degree of co-movement, has severely increased since the beginning of the financial crisis, and remains at elevated levels. We document that the state of a country's domestic financial system, and since the beginning of the crisis also the state of the world financial system have strong explanatory power for the behavior of CDS spreads, and that the magnitude of this impact depends on the relative importance of a country's financial system pre-crisis. Furthermore, it matters whether a country is a member of the Economic and Monetary Union of the European Union (EMU), in that their sensitivities to the health of the financial system are higher compared to non-EMU members. While one would expect the unconditional risk of default to be low in case of advanced economies, our results suggest the presence of an important economic channel in adverse economic times: a private-to-public risk transfer through which market participants incorporate their expectations about financial industry bailouts and the potential burden of government intervention