How Does Trust Impact Sovereign Credit Default Swap Spreads?

Abstract

Trust is a key aspect underpinning any market or transaction, particularly within sovereign credit default swap (SCDS) markets, yet the question of its impact on its pricing has been left unanswered. This thesis seeks to analyse the spreads of SCDS across a wide range of countries and answer the question: how does the level of trust that global investors have in a nation influence these spreads? Through an extensive empirical analysis and novel theoretical discussion, we seek to further the field of sovereign behavioural finance. This study suggests that there are three key effects in SCDS markets relating to trust. The first is the Economic Development Effect, where countries with higher GDP per capita have more favourably priced SCDS due to their superior economic development, and not any fundamental factors. Secondly, a Financial Development Effect is found where countries with more developed markets and institutions additionally have lower SCDS spreads due to this development alone. Thirdly is the Unobserved Effect, whereby sovereign spreads are influenced by a large degree of unobserved country heterogeneity. All three effects are highly economically and statistically significant, and we suggest that these observations are due to the underlying beliefs and preferences of international investors. These effects are captured through the creation of a Trust Index, which provides a ranking of the most trusted countries in the context of debt repayment. This index highlights the differential treatment of nations by global investors in credit which, in a time of record-high global sovereign debt levels, should be carefully scrutinised.