An analysis of euro area sovereign CDS and their relation with government bonds

•We analyse the relation between euro area sovereign CDS and government bonds spreads.•We document sizable deviations from parity during the euro area sovereign crisis.•Short-selling frictions and “flight-to-quality/liquidity” explain the positive basis.•Funding frictions and bond illiquidity partly explain negative basis deviations.

We compare the market pricing of euro area government bonds and the corresponding Credit Default Swaps (CDSs). In particular, we analyse the “basis” defined as the difference between the premium on the CDS and the credit spread on the underlying bond. Our sample of weekly data covers the period from January 2007 to December 2012 and contains several episodes of sovereign market distress. Overall, we observe a complex relationship between the derivatives market and the underlying cash market characterised by sizable deviations from the no-arbitrage relationship (i.e. basis equal to zero). We show that short-selling frictions explain the persistence of positive basis deviations while funding frictions explain the persistence of negative basis deviations which are observed for countries with weak public finances. Moreover, we show that the “flight-to-quality/liquidity” phenomenon in bond markets is a key driver of the large positive basis of better rated countries.