Sovereign default risk, overconfident investors and diverse beliefs: Theory and evidence from a new dataset on outstanding credit default swaps

In standard public finance theory a government's cost of borrowing depends on the common beliefs held by rational investors regarding default risk. We advance understanding of the effects of diverse beliefs and overconfidence among investors in their ability to assess the sovereign's creditworthiness. Theoretically, we find that demand for insurance against default is positively related to the absolute difference between the market price of sovereign risk and the risk forecasted by the economy's fundamentals. We find preliminary support for this prediction in a newly available dataset on sovereign credit default swaps (CDSs): after controlling for the size of the public debt, the absolute size of the gap between the actual and forecasted spreads is positively related to the value of outstanding CDSs.

► We advance the understanding of heterogeneous investor expectations and overconfidence on trade in credit default swaps.
► The model predicts a positive association between public debt, CDS outstanding, and forecasting error on CDS spreads.
► Using a new dataset on outstanding sovereign credit default swaps, we find preliminary support for the predictions.