Ripples into waves: trade networks, economic activity, and asset prices, a paper co-authored by our school’s Assistant Prof. Du Huancheng, Prof. Jeffery Chang Jinfan from the Chinese University of Hong Kong (Shenzhen), Prof. Lou Dong and Prof. Christopher Polk from the London School of Economics and CEPR, was accepted by Journal of Financial Economics, a world-class journal on finance.
Credit default swaps (CDSs), are a type of very important financial derivative assets. As an insurance product in nature, purchasers of CDSs are entitled to compensation when the bonds they insure against default by paying a premium on a regular basis. By nature of the bonds insured against, CDSs can be further divided into sovereign CDSs and corporate CDSs. After sovereign CDSs were introduced to the international financial market in the 1990s, the market for them grew steadily, which also became one of the causes of the global financial crisis in 2007-2008. At the end of 2007, the global CDS market already reached US$6.1 trillion. After the global financial crisis, due to market regulation and crackdown, the overall CDS market is shrinking, but the market share of sovereign CDSs is still growing.
Through empirical study, the authors find that valuable information is contained in the prices of derivatives such as sovereign CDSs. This paper shows that the global average quarterly price of sovereign CDSs is notably negatively correlated with the growth rate of the global average GDP, with a correlation coefficient at -0.67. This further indicates that the price of sovereign CDSs can well reflect the credit risk and economic activity of a sovereign country at a high frequency (by month, week, quarter). An in-depth probe into the price of sovereign CDSs as shown in this paper is of great significance to better understanding global systemic risks and the cycle of international economic activities.
This paper first proposes an important factor that influences and determines the price of sovereign CDSs: credit risk and economic performance of trading partners that have trade ties with a specific sovereign country. The authors find that the average sovereign CDS price in the last three months in export destination countries can strongly predict the sovereign CDS price of the exporting country in the following month. The long/short strategy that sorts sovereign CDS contracts into groups by their average cumulative prices in the last three months in export destinations can fulfill an annualized excess return of 5%, with a Sharpe ratio of 1.1. Furthermore, the authors find that such price predictability is more pronounced for countries which are on the periphery of the international trade network and more financially vulnerable. This paper further investigates and analyzes the substantive transmission mechanism behind such predictability through the following empirical tests.
Firstly, it is proved through two natural experiments that country-level short-term economic shocks propagate across the international trade network, thereby generating direct impact on trading partners of exporting countries. The two natural experiments were the Japanese tsunami in 2011 and the COVID-19-induced Wuhan lockdown in 2020. Both considered sufficiently exogenous, the two incidents still had such huge influence as to shake the credit risk and short-term economic development of two sovereign countries. Empirical evidence shows that the price of China’s and Japan’s sovereign CDSs rose obviously the day the two incidents occurred. The authors conduct a cross-sectional regression of the sovereign CDS prices in countries that exported to China and Japan within five days and four weeks of the occurrence of the incidents, and find that the coefficient on a share of such countries’ exports is significantly positive, and the value and significance of the coefficient will gradually diminish as time evolves. This shows that when a country suffers external economic shocks, such shocks will propagate to upstream countries (exporting countries) through the international trade network. The paper further reveals that predictability of sovereign CDS prices is mainly reflected in the propagation along export chains, with no evident results found in respect of import chains.
Secondly, this paper finds that the transmission mechanism of economic shocks is not applicable only to countries with direct trade ties, as such shocks will propagate further through the trade network and influence indirect trade partners. For instance, the negative economic shocks caused by Japan’s tsunami affected China, its direct export destination, thereby further influencing the latter’s export destinations such as the United States.