Introduction                         Methodology                              ResultsLiquidity Spillovers in Sovereign Bon...
Introduction                             Methodology                                  ResultsEurozone Sovereign Crisis    ...
Introduction                           Methodology                                ResultsOutline of Talk     Brief overvie...
Introduction                             Methodology                                  ResultsLiquidity and Price Formation...
Introduction                             Methodology                                  ResultsLiquidity and Price Formation...
Introduction                               Methodology                                    ResultsA Time Varying Vector Aut...
Introduction                       Methodology                            ResultsWe have developed a least squares based a...
Introduction                        Methodology                             Results                                       ...
Introduction                            Methodology                                 ResultsVariance breakpoint tests     A...
Introduction                            Methodology                                 ResultsData set     Given the controve...
Introduction                            Methodology                                 ResultsCountries in sample     We coll...
Introduction                        Methodology                             ResultsABN AMRO                           ANZ ...
Introduction                            Methodology                                 ResultsCountry           Ticks   Zero ...
Introduction                             Methodology                                  ResultsResults     Large number of r...
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Introduction                                                   Methodology                                                ...
Introduction                                                    Methodology                                               ...
Introduction                                                   Methodology                                                ...
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Introduction                                                  Methodology                                                 ...
Introduction                                                  Methodology                                                 ...
Introduction                                                  Methodology                                                 ...
Introduction                              Methodology                                   ResultsDetected First Variance Bre...
Introduction                             Methodology                                  ResultsNext Few Slides     Document ...
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Introduction                                Methodology                                     ResultsGreek 5 year model first...
Introduction                                  Methodology                                       ResultsGreek 5 year model ...
Introduction                                  Methodology                                       ResultsGreek 5 year model ...
Introduction                                Methodology                                     ResultsGreek 5 year model four...
Introduction                            Methodology                                 ResultsObservations     Most important...
Introduction                              Methodology                                   ResultsPolicy Implication      Set...
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Giovanni Calice. Spillovers in Sovereign Bond and CDS Markets: An Analysis of The Eurozone Sovereign Debt Crisis

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Open seminar in Eesti Pank, 26 March 2013

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Giovanni Calice. Spillovers in Sovereign Bond and CDS Markets: An Analysis of The Eurozone Sovereign Debt Crisis

  1. 1. Introduction Methodology ResultsLiquidity Spillovers in Sovereign Bond and CDSMarkets: An Analysis of The Eurozone Sovereign Debt Crisis Giovanni Calice School of Management, University of Southampton, England, U.K. Jing Chen School Business and Economics, Swansea University, Wales, U.K. Julian Williams Business School, University of Aberdeen, Scotland, U.K. February 2012 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  2. 2. Introduction Methodology ResultsEurozone Sovereign Crisis Ongoing issue of liquidity and solvency of various EU governments. Causes are diverse (poor fiscal planning in Portugal, expensive bank guarantees in Ireland, falsified national accounts in Greece) At present Greece, Portugal and Ireland are in receipt of financial guarantees and liquid capital injections via the IMF, EFSF and asset purchases by the ECB. Iceland has also received a substantial ‘bail-out’ after the collapse of its banking system, earlier on in the crisis. Causes are well known and are for other discussions. This paper looks at the mechanism of transmission of liquidity and information in the price formation mechanism of Eurozone sovereign debt during the 2007-2011 period. The paper provides a table of various macroeconomic indicators for 2007, 2008, 2009 and 2010 versus the 2001-2006 average. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  3. 3. Introduction Methodology ResultsOutline of Talk Brief overview of our research questions and methodology. Our data and the uniqueness of the data set. A short tour of some of the main results. Brief concluding remarks. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  4. 4. Introduction Methodology ResultsLiquidity and Price Formation in Crises Variables Let BON Dt be the yield (or discount premia) for each countries sovereign debt (for either 5 or 10 year maturities) measured in basis points. CDSt is the credit default swap rate, in basis points for each country. BON DDE,t and CDSDE,t are respectively the yield and CDS spread on German sovereign debt of 5 and 10 year maturity. BON DBIDt is the bid yield in basis points for sovereign bonds and BON DASKt is the ask yield for sovereign bonds, again converted to basis points. CDSBIDt and CDSASKt are, respectively, the bid and ask spreads for 5 and 10 year sovereign CDS in basis points. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  5. 5. Introduction Methodology ResultsLiquidity and Price Formation in Crises Our key research question is to establish the dynamics of interaction between the credit spread on traded Eurozone sovereign debt with the credit spread on equivalent maturity sovereign CDS and the liquidity spreads on traded sovereign debt and CDSs. For each country we compute the BON DCSt , the sovereign bond credit spread, the CDSCSt , the CDS credit spread, the BON DLSt , the sovereign bond liquidity spread and finally the CDSLSt , the CDS liquidity spread. These are computed as follows: BON DCSt = BON Dt − BON DDE,t (1) CDSCSt = CDSt − CDSDE,t (2) BON DLSt = BON DBIDt − BON DASKt (3) CDSLSt = CDSBIDt − CDSASKt (4) GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  6. 6. Introduction Methodology ResultsA Time Varying Vector Autoregression In this paper we provide results for an endogenous time varying VAR model of price and liquidity formation for sovereign bond and CDS markets during the crisis. BON DCSt = β1,1,t BON DCSt−1 + β1,2,t CDSCSt−1 +β1,3,t BON DLSt−1 + β1,4,t CDSLSt−1 + µ1,t + u1,t CDSCSt = β2,1,t BON DCSt−1 + β2,2,t CDSCSt−1 +β2,3,t BON DLSt−1 + β2,4,t CDSLSt−1 + µ2,t + u2,t BON DLSt = β3,1,t BON DCSt−1 + β3,2,t CDSCSt−1 +β3,3,t BON DLSt−1 + β3,4,t CDSLSt−1 + µ3,t + u3,t CDSLSt = β4,1,t BON DCSt−1 + β4,2,t CDSCSt−1 +β4,3,t BON DLSt−1 + β4,4,t CDSLSt−1 + µ4,t + u4,t (5) the coefficients [βi,j ] are collected into the time varying matrix Bt . GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  7. 7. Introduction Methodology ResultsWe have developed a least squares based alternative to the Kalmanfilter that is robust to structural change, whilst being able to capturelocal stability in the coefficients.We call this approach recursive and iteratively re-weighted leastsquares (IRLS), which might be thought of as a specific class of theextended least squares approach.More specifically, the model is a multivariate extension of the singleequation autoregressive model of Arvastson et al. 2000 which is astandard autoregressive model with time varying coefficientsestimated with exponential forgetting. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  8. 8. Introduction Methodology Results ˜The eigenvalues of the time varying matrix Bt offer valuableinformation on the instantaneous stability of the autoregressivemodel.Consider the time varying eigenvalues of the 4 × 4 slope matrix Bt , ˜ordered from largest to smallest as {λmax,t , λ2,t , λ3,t , λmin,t }.We have imposed a first order VAR on the time varying coefficients,therefore the eigenvalues of this matrix correspond directly topolynomial roots of the VAR process.If the range of λmax,t to λmin,t is within the unit circle then theinstantaneous static VAR at time t is stationary. A root equal to oneindicates the presence of at least one random walk in the vectorsystem.Roots greater than unity indicate an explosive stochastic trend. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  9. 9. Introduction Methodology ResultsVariance breakpoint tests Another helpful by-product of the recursive regression approach is that a standard matrix equality test can be used to extend the standard variance break point tests for structural breaks, By use of a Wishart style covariance equality test, details are in the paper. The idea is to identify whether the conditional covariance matrix at t is equal to the long run covariance matrix Σ from the model residuals. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  10. 10. Introduction Methodology ResultsData set Given the controversy surrounding the reporting of various credit spread indices, we have constructed our data set, where possible, from the transaction history. The data set is sourced from Thomson-Reuters Tick History and DataStream. Sovereign bond data is collected using the ‘Super RICs’ or Reuters Information Codes. The super-RICs collect all trades on instruments in the tag range set by the code, i.e. AT5YT=RR literally means pull all yields on traded bonds with a 5 year maturity from the daily collection date. We use the same approach for the CDS market, however aggregation is much more complex. Multiple data vendors provide an array of intra-day and end-of-day information, through Markit and CMA. The CDS data set is then hand built from these sources and combined into a daily index. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  11. 11. Introduction Methodology ResultsCountries in sample We collect all traded sovereign bonds with a maturity of 5 and 10 years for the countries selected in the sample. Originally all Eurozone countries were included in the sample. However, credit default swaps have only been actively traded on ten countries for a long enough period to permit analysis. These countries are Austria, Belgium, France, Germany (the benchmark), Greece, Ireland, Italy, Netherlands, Portugal and Spain. The next slide lists the various CDS sources that CMA and Markit use when building the index of daily spreads. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  12. 12. Introduction Methodology ResultsABN AMRO ANZ Investment Bank (Asia)Barclays CDS NYC Barclays TokyoBNP Paribas Citigroup Global MktsDeutsche Bank NY Deutsche Bank SingaporeDZ Bank, Frankfurt GFI Market RecapHandelsbanken HypovereinsbankICAP ING ManilaJ.P.Morgan Mizuho SecuritiesNatexis Nord LB, HannoverRBS Japan SEBStandard Chartered Singapore TIFFETullett Prebon UBS JapanUBS Singapore CMAMarkit GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  13. 13. Introduction Methodology ResultsCountry Ticks Zero Yields Corrupted Rogue Trading DaysSpain 4,010,003 606 0 24 1,339Austria 5,609,129 348 0 12 1,339Belgium 978,395 55,981 0 0 1,339France 708,122 31,168 0 2 1,339Germany 2,141,828 61 0 2 1,339Greece 2,800,111 18,574 0 4 1,339Ireland 3,151,086 4,982 0 6 1,339Italy 3,800,255 299,131 0 3 1,339Netherlands 4,866,969 593 0 4 1,339Portugal 4,616,628 10,253 0 3 1,339 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  14. 14. Introduction Methodology ResultsResults Large number of results in the paper, appendix and internet appendix. The results are ordered in the paper as follows: Breakpoint tests (points at which the market has appeared to change pricing model). Time varying roots (detecting the presence of explosive stochastic trends, helpful for policy makers). Time varying coefficients (direction of price discovery mechanism in the market). First: A visual inspection of the data for Greece, Ireland, the Netherlands and France. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  15. 15. Introduction Methodology ResultsGreek credit spreads Credit Spreads 5 Year 1400 Bond 1200 CDS 1000 800 600 400 200 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Credit Spreads 10 Year 1000 Bond CDS 800 600 400 200 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  16. 16. Introduction Methodology ResultsGreek liquidity spreads Liquidity Spreads 5 Year 250 Bond CDS 200 150 100 50 0 −50 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Liquidity Spreads 10 Year 120 Bond CDS 100 80 60 40 20 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  17. 17. Introduction Methodology ResultsIrish credit Spreads Credit Spreads 5 Year 500 Bond CDS 400 300 200 100 0 −100 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Credit Spreads 10 Year 500 Bond CDS 400 300 200 100 0 −100 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  18. 18. Introduction Methodology ResultsIrish liquidity Spreads Liquidity Spreads 5 Year 80 Bond 70 CDS 60 50 40 30 20 10 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Liquidity Spreads 10 Year 40 Bond 35 CDS 30 25 20 15 10 5 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  19. 19. Introduction Methodology ResultsDutch credit spreads Credit Spreads 5 Year 100 Bond CDS 80 60 40 20 0 −20 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Credit Spreads 10 Year 120 Bond 100 CDS 80 60 40 20 0 −20 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  20. 20. Introduction Methodology ResultsDutch liquidity spreads Liquidity Spreads 5 Year 30 Bond CDS 25 20 15 10 5 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Liquidity Spreads 10 Year 35 Bond 30 CDS 25 20 15 10 5 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  21. 21. Introduction Methodology ResultsFrench credit spreads Credit Spreads 5 Year 100 Bond CDS 80 60 40 20 0 −20 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Credit Spreads 10 Year 70 Bond 60 CDS 50 40 30 20 10 0 −10 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  22. 22. Introduction Methodology ResultsFrench liquidity spreads Liquidity Spreads 5 Year 20 Bond CDS 15 10 5 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 Liquidity Spreads 10 Year 15 Bond CDS 10 5 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  23. 23. Introduction Methodology ResultsDetected First Variance Breakpoints Austria (AT) Belgium (BE) 5 Year 10 Year 5 Year 10 Year February 2008 May 2007 August 2007 May 2008 France (FR) Greece (GR) 5 Year 10 Year 5 Year 10 Year March 2008 January 2007 January January 2007 Ireland (IE) Italy (IT) 5 Year 10 Year 5 Year 10 Year May 2008 September 2008 March 2008 November 2009 Netherlands (NL) Portugal (PT) 5 Year 10 Year 5 Year 10 Year March 2008 January 2007 February 2008 March 2010 Spain (ES) 5 Year 10 Year March 2008 August 2007 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  24. 24. Introduction Methodology ResultsNext Few Slides Document the time varying roots of the first order coefficients matrix, for Greece and Portugal. Roots above unity indicate the presence of explosive trends. Roots equal to one indicate that there is at least one random walk in the vector process. In our internet appendix, we document the results for every country and adjust the nuisance parameters in the weighting system to illustrate the robustness of the results. For the smallest root, if it is very large, then this indicates a jointly explosive trend. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  25. 25. Introduction Methodology Results5 year Greek model roots. Roots 1.4 Largest Root Smallest Root 1.2 1 0.8 0.6 0.4 0.2 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  26. 26. Introduction Methodology Results10 year Greek model roots. Roots 1.2 Largest Root Smallest Root 1 0.8 0.6 0.4 0.2 0 −0.2 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  27. 27. Introduction Methodology Results5 year Portuguese model roots. Roots 1.2 Largest Root Smallest Root 1.1 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  28. 28. Introduction Methodology Results10 year Portuguese model roots. Roots 1.4 Largest Root Smallest Root 1.2 1 0.8 0.6 0.4 0.2 0 Q1−07 Q2−07 Q3−07 Q4−07 Q1−08 Q2−08 Q3−08 Q4−08 Q1−09 Q2−09 Q3−09 Q4−09 Q1−10 Q2−10 Q3−10 Q4−10 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  29. 29. Introduction Methodology ResultsGreek 5 year model first equation β 1,1,t β 1,2,t 0.15 1.1 0.1 1 0.05 0.9 0 0.8 −0.05 0.7 −0.1 0.6 −0.15 0.5 −0.2 2008 2009 2010 2008 2009 2010 β 1,3,t β 1,4,t 0.6 0.5 0.4 0.4 0.3 0.2 0.2 0.1 0 0 −0.1 −0.2 −0.2 −0.3 −0.4 −0.4 2008 2009 2010 2008 2009 2010 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  30. 30. Introduction Methodology ResultsGreek 5 year model second equation β 2,1,t β 2,2,t 0.4 1.1 0.35 1 0.3 0.25 0.9 0.2 0.8 0.15 0.1 0.7 0.05 0 0.6 −0.05 0.5 2008 2009 2010 2008 2009 2010 β 2,3,t β 2,4,t 1.2 0.3 1 0.2 0.1 0.8 0 0.6 −0.1 0.4 −0.2 0.2 −0.3 0 −0.4 −0.5 −0.2 −0.6 −0.4 2008 2009 2010 2008 2009 2010 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  31. 31. Introduction Methodology ResultsGreek 5 year model third equation β 3,1,t β 3,2,t 0.4 0.6 0.3 0.4 0.2 0.1 0.2 0 0 −0.1 −0.2 −0.2 −0.3 −0.4 −0.4 −0.5 2008 2009 2010 2008 2009 2010 β 3,3,t β 3,4,t 1.5 0.8 1 0.5 0.6 0 0.4 −0.5 0.2 −1 −1.5 0 −2 −0.2 −2.5 2008 2009 2010 2008 2009 2010 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  32. 32. Introduction Methodology ResultsGreek 5 year model fourth equation β 4,1,t β 4,2,t 0.5 0.6 0.4 0.2 0 0 −0.2 −0.5 2008 2009 2010 2008 2009 2010 β 4,3,t β 4,4,t 2.5 1 2 0.8 1.5 0.6 1 0.4 0.5 0.2 0 0 2008 2009 2010 2008 2009 2010 GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  33. 33. Introduction Methodology ResultsObservations Most important take home messages: Explosive trends present at times in almost all Eurozone countries and in particular Greece, Ireland and Portugal. At this point the market has ceased to function in the normal manner. Without intervention the discount rate would have been driven to infinity. There is a time varying transmission effect from the CDS liquidity spread to the bond market credit spread (violates the nearly complete market condition of Jarrow-Protter 2005). GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets
  34. 34. Introduction Methodology ResultsPolicy Implication Setting the effective rate of interest using the market rates, just prior to bailout is inappropriate. At this point the market has ceased to price new information and default is already priced in, before it has happened. This is most certainly a liquidity effect. At points this liquidity effect is NOT from the bond market, but from the CDS. Which the authors believe is part of a case for banning what should be a redundant asset. GC,JC & JW Liquidity Spillovers in Sovereign Bond and CDS Markets

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