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Sovereign Credit Spread and CDS Models with Macro Factors: a Case of Brazilian Global

By Zhuoshi Liu


This paper applies macro-finance models to study the default and liquidity components of the Brazilian sovereign spread by using the information in the CDS markets. Following Longstaff, Mithal, and Neis (2005), I assume that the Brazilian CDS spread only includes the default components. However the spread of a sovereign bond includes both default and liquidity components. Thus, the direct measure of the default and liquidity components in the sovereign spreads can be obtained by using the the CDS spread data. The results show that the default premium explains a major part of the sovereign spread in most of the period, particularly when default risks are high. The liquidity premium, however, may dominate the sovereign spread when the default risk is very low. The latent country risk and liquidity factors are the most important factors in determining the sovereign spreads. The effects of the US interest rates on sovereign spreads are negligibly small. Another important result of my research is that Brazilian sovereign bonds are over priced (implied by the negative liquidity components) in most of the period and that they are particularly expensive for the very low risk period. This seems to suggest that the recent historically low sovereign spread is not only the result of the perceived low default risk in Brazil but also the result of the strong demand for the Brazilian sovereign bond due to excess global liquidity.

Year: 2007
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