Has the Relationship Between Market and Model CDS Price Changed during the EMU Debt Crisis?

Basic purpose of a credit default swap (CDS) is to protect its buyer against a default of a reference entity. During the ongoing EMU debt crisis this purpose was questioned when Greek default was postponed continuously and actions of European public authorities gave rise to speculations that Greece could effectively default without CDS protection payment being triggered. In this article we examine whether this development in Greek case influenced CDS price of EMU member states in general, i.e. whether investors’ trust in this instrument decreased. Our presumption is that if there are no uncertainties about the CDS contract conditions, market price of a CDS should be closely related to its modelled risk-neutral fair price. In the first part of the article we use adopted reduced form CDS valuation model to obtain model CDS price which is compared to market CDS price in the second part of the article using two methods: heteroskedasticity- and autocorrelation-robust estimates and Johansen cointegration test. The main finding of this article is that the relationship between market and model CDS price mostly weakened during the crisis. More interestingly, using the first method it weakened in case of all riskier countries such as Portugal, Italy, Ireland, Spain and Belgium and this trend is not confirmed in case of safer countries such as Finland, France, Netherlands and Austria. In both methods we take into account a role of counterparty and liquidity risk and conclude that whereas counterparty risk role increased during the crisis, liquidity risk does not seem to play an important role in CDS market price determination.