A View from Outside: Sovereign CDS Volatility as an Indicator of Economic Uncertainty

A sovereign credit default swap (CDS) compensates for losses when a country defaults on its debt. The periodic premium payment for such default protection is the so called CDS spread. The volatility of sovereign CDS spreads reflects the amount of uncertainty of CDS traders about the level the spreads. As sovereign CDS contracts are mainly written by leading global financial institutions, sovereign CDS volatility captures the uncertainty of these institutions about the economic conditions in a country. In this paper, we investigate the merits of sovereign CDS volatility as an indicator of economic uncertainty for a broad panel of 16 countries. Using directional forecast evaluation methods, we find that sovereign CDS volatility does contain information about economic policy uncertainty (EPU) as measured by popular news-based EPU indices. Furthermore, using Bayesian panel VARs, we estimate the responses of output and unemployment after an unexpected increase in economic uncertainty measured with CDS volatility and compare them with responses obtained with EPU indices and other measures of economic uncertainty. Our results indicate that the responses to CDS volatility shocks are qualitatively similar to the responses to EPU index shocks. However, the responses to shocks to CDS volatility can be estimated more precisely.