The theory of complete markets suggests that sovereign debt and credit default swap (CDS) credit spreads should track each other closely. In addition, liquidity risk should be priced into both instruments in such a way that buying exposure to the same default risk is identically priced, given appropriate collateral requirements for the hedging instruments and the payout structure in the CDS providing the desired recovery on the defaulting cash flow instrument. Therefore, we have developed an empirical model of the co-evolution of credit and liquidity spreads in sovereign bond and CDS markets to study the liquidity and credit interactions for Eurozone countries over the 1 January 2007 to 1 October 2010 period, a period commonly referred to as the Eurozone sovereign debt crisis. During November 2009, shortly after the election of a new Greek government, the Greek public sector deficit was revised from 6 per cent to 12.7 per cent of GDP. This event initiated a sovereign debt crisis that has resulted in large financial interventions in financial markets and fiscal policies in Greece, Ireland and Portugal and is often referred to as the ‘Eurozone sovereign debt crisis’.
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