What Drives Systemic State Credit Risk? Evidence from the State Credit Default Swap (CDS) Market

Abstract

In this article, using state credit default swap data, the authors examine the role of common macroeconomic factors in driving systemic sovereign credit risk. Using a structural model with jump risk, the authors demonstrate that co-movement in state economic fundamentals is an important channel of systemic credit risk. Empirical evidence shows that changes in macroeconomic fundamentals explain more variations in state credit spread and its systemic component than do financial market variables. This evidence points to macroeconomic linkages, not financial linkages, as the leading source of systemic state credit risk and suggests that this risk is driven mainly by weakness in economic fundamentals.