Regime-switching determinants of emerging markets sovereign credit risk swaps spread

Using the Markov regime switching approach, the authors investigate the dependency of short term sovereign credit default swap (SCDS) spread changes on a nation's country-specific fundamental factors, local, regional and macroeconomic global factors. They find that the significance of the determinants of SCDS spread changes differ across the two states of our regime-switching model. Specifically, in the "good" state the weekly SCDS spread changes are mainly determined by local, regional and fundamental factors; whereas global variables have stronger influence in the "bad" regime. In particular, US market returns play a dominant role in influencing the SCDS spread change in the "bad" state suggesting loss aversion and flight to quality behavior of investors. The authors then examine the cross-sectional differences of the above regime switching effect based on country-specific characters and find that the regime switching effect is associated with a nation's country-specific characters such as openness, economic size, etc.