The Impact of Collateral Policies on Sovereign CDS Spreads

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Giovanni Calice

Giovanni Calice, a professor at the University of Southampton, builds in this paper a new theoretical model for pricing of credit default swap (CDS) contracts with asymmetric collateralisation agreements. The study, one of the few in the field, represents a timely contribution to the discussion on the financial links between asymmetric collateralisation and the related hedging activities by Credit Value Adjustment (CVA) desks on the market for sovereign CDS.

Calice finds that CDS prices are related to collateral costs and so to the operation of CVA desks of financial institutions. It follows that not posting collateral on derivatives transactions, a widespread practice by sovereigns, may increase borrowing costs in particular for countries that have a significant amount of notional outstanding CDSs contracts. This situation means that, in an asymmetric collateralisation transaction, the increase of CDS spreads may affect the cost of debt, exacerbating an already unstable situation. The study also considers why, during the euro area sovereign debt crisis, CVA practices (such as hedging asymmetric collateralisation) have emerged as one of the variables that have influenced the evolution of sovereign CDS markets.

The Association for Financial Markets in Europe (AFME), the International Capital Market Association (ICMA) and the International Swaps and Derivatives Association (ISDA) have sponsored this study as part of a paper series drafted by key international experts on financial markets issues.