Sovereign credit risk is an important consideration for investors, academics, and practitioners in the countries, and CDS spreads play a leading role to handle credit risk. The CDS premium has been mainly used as a market-based reference for sovereign credit risk. The increasing popularity of CDS spreads has brought into question whether there is a relation between CDS spreads and financial factors. To this end, the aim of this research is to explore the effect of financial factors on CDS in Turkey using the ARDL models. The results confirm that Brent and VIX volatility have an asymmetric relationship with CDS spreads in Turkey. The empirical findings suggest that a positive shock in VIX causes an increase in CDS spreads. The asymmetry in the relationships between CDS and financial factors highlights important policy implications for portfolio and risk management and financial stability.
TopIntroduction
The investors who want to fund in the countries especially developing countries have data related to the market to make convenient and reliable decisions. Nevertheless, it is difficult and cost for each investor to reach that data with their potentials (Dinc et al., 2018: 182). Within the decision stages of the direct and indirect investments proposed to be made, evaluating the credit risk of the countries correctly and transparently has become important (Sarigul and Sengelen, 2020: 206). In recent years, country risk has become an important indicator for investors who want to make direct investments or portfolio investments, especially in emerging markets.
Risks of countries are not only related to the economic indicators; they can also change depending on the several policies followed by the current political parties within the country. The country risk perception of the investors has been formed for long years by considering the “sovereign ratings” which are generally provided by the credit rating agencies (Bozkurt, 2015: 65). Therefore, one of the leading indicators indicating the risk status of the countries is the sovereign ratings. However, the fact that several economic departments with high credit ratings took to the cleaners because of the crises has caused the question marks to be left over the minds of economists and experts for the credibility of the credit ratings. The credit rating agencies have been criticized recently since their ratings are insufficient to reflect the risks of the countries (Ferri et al., 1999; Mora, 2006). It caused people to apply for the methods alternative for the ratings provided by the credit rating agencies. With the global crisis in 2008, the bankruptcy of Lehman Brothers made the question whether the credit ratings provided by the credit rating agencies reflect the reality as a current issue, thus the need for avoiding from the risks gained a new dimension (Atmisdortoglu, 2019: 42; Avci, 2020: 2) and then the CDS spread were proposed as indicators which can be alternative for the ratings of the credit rating agencies (Flannery et al., 2010: 2085). In recent times, CDS has become a part of the financial markets as an important indicator by the credit rating agencies. Hence, CDS has started to be considered as one of the main determinants of the credit risk of countries and the risk perception of international investors (Kajurova, 2015: 1302; Fettahoglu, 2019: 268).
CDS, which shows the solvency and credibility of countries, came into existence to the financial markets in 1994 when they were introduced by Blythe Masters from JP Morgan. Credit default swap (CDS) is a bilateral financial contract protecting the creditor in return for a certain spread against the default risk of a credit. Along with being a financial contract, these are derivative products that express the risks of the relevant country in the form of spreads over the government bonds and Euro Bonds they take as reference assets (Tanyildızi and Yigiter, 2021: 182). These spreads are expressed in basis points and if the reference asset is a bond, they are calculated over the nominal value of the bond. The CDS market, which shows the financial success of the creditor country, is used by market participants as a market-based indicator for country credit risk (Bouri et al., 2017: 155). An increase on the spreads of CDS indicates an increased probability of default and thus higher borrowing costs and it leads to increased concerns in the markets (Kilci, 2019: 76). Since it inevitably reflects on the interest; the higher CDS spread of a country or a company, the higher borrowing costs. As your CDS spread increases, both your interest rate will also increase and the amount of debt you can receive and the number of people willing to lend will decrease. As a matter of fact, countries and institutions within the relevant country with high CDS spread are exposed to higher costs to meet their borrowing needs (IMF, 2013: 13). Since the CDS spread take a position by considering the political and economic risk management, the CDS spread change every hour and they are timelier and more dynamic than sovereign ratings (Baker and Filbeck, 2015; Damodaran, 2015: 40). Therefore, the data on CDS spread can be followed instantly compared to the ratings provided by the rating agencies (Kaya et al, 2015: 559). CDS spread of countries are expressed as base points of the cost which the investor must pay for the CDS contract to be purchased against the default risk.