The CDS Bond Basis Spread in Emerging Markets: Liquidity and Counterparty Risk E¤ects (Draft)

This paper explores the parity between CDS premiums and bond spreads for emerging market sovereign entities. Previous studies found that this parity holds between bonds and CDSs for US corporate debt. We …nd that this parity does not hold for Emerging Markets sovereign debt. In order to explain the pricing deviations we focus on two frictions, liquidity and counterparty risk. First, we present a model where the two market frictions account for the deviations in prices. Then, our empirical results strongly support the relevance of these two factors to the pricing of CDS contracts. We mange to restore much of the theoretical predictions of a zero basis spread once we account for liquidity e¤ects. 1 Introduction A Credit Default Swap (CDS) is a credit derivative that provides protection against a bond default. Theory suggests that under ideal market conditions, due to arbitrage forces, CDS premiums should be equal to the underlying bond yield spread over the risk-free rate. However, in sharp contrast to this theoretical prediction, we …nd that CDS premiums consistently deviate from bond yield spreads for emerging market sovereign debt. Using an extensive data set we document a non-zero basis spread between CDSs and their underlying bonds. In order to account for these deviations we present a model with two market frictions. We …rst allow for liquidity di¤erences between CDSs and bonds. Liquidity di¤erences introduce di¤erent liquidity premiums into the pricing of each asset, which consequently generate pricing inequalities between CDSs and bonds. Second, we allow for the existence of counterparty