Essays in Financial Economics: Currency Risk and Pricing Kernal Volatility, CDS and Sovereign Bond Market Liquidity, CDS as Sovereign Debt Collateral
Essay 1: CDS and Sovereign Bond Market Liquidity During the recent debt crisis in Europe, policy makers responded to the controversy surrounding CDS by implementing a series of policies that banned CDS trading. I use these bans as quasi-natural experiments to identify how derivative markets affect liquidity of the underlying cash market. I document that a temporary CDS ban increased bond market liquidity but a permanent ban instead decreased bond market liquidity. To explain these patterns, I build a dynamic search-theoretic model of over-the-counter bond and CDS markets that features an endogenous liquidity interaction between the two markets. My model shows that these opposing patterns are due to the fact that bond and CDS markets are substitute markets in the short run but are complementary markets in the long run. My results challenge existing theories of liquidity interaction among multiple markets and the common perception that the CDS market is a more liquid market than the bond market. Essay 2: CDS as Sovereign Debt Collateral A defining friction of sovereign debt is the lack of collateral that can back sovereign borrowing. This paper shows that credit default swaps (CDS) can serve as collateral and thereby support more sovereign borrowing. By giving more bargaining power to lenders in ex-post debt renegotiations, CDS becomes a commitment device for lenders to extract more repayment from the debtor country. This ex-post disciplining effect during debt renegotiations better aligns the sovereign’s ex-ante incentives with that of the lender. CDS alleviates agency frictions that are present in any lending contracts but are particularly difficult to mitigate in sovereign debt context. Essay 3: Currency Risk and Pricing Kernel Volatility A basic tenet of lognormal asset pricing models is that a risky currency is associated with low pricing kernel volatility. Empirical evidence indicates that a risky currency is associated with a relatively high interest rate. Taken together, these two statements associate high-interest-rate currencies with low pricing kernel volatility. We document evidence suggesting that the opposite is true, thus contradicting a fundamental empirical restriction of lognormal models. Our identification strategy revolves around using interest rate volatility differentials to make inferences about pricing kernel volatility differentials. In most lognormal models the two are monotonic functions of one another. A risky currency, therefore, is one with relatively low pricing kernel volatility and relatively low interest rate volatility. In the data, however, we see the opposite. High interest rates are associated with high interest rate volatility. This indicates that lognormal models of currency risk are inadequate and that future work should emphasize distributions in which higher moments play an important role. Our results apply to a fairly broad class of models, including Gaussian affine term structure models and many recent consumption-based models.