Does economic policy uncertainty drive CDS spreads?

Abstract

This study analyzes the dynamic interactions between changes in economic policy uncertainty and the fluctuations in the cost of credit protection. We find that the differenced iTraxx and CDX indices are Granger-caused by variations in the political environment. Within a vector autoregressive framework, impulse response functions show a significant reaction of the CDS spreads to shocks in the policy risk. Implied in these findings is the possibility that country-level risk can permeate to the corporations. Furthermore, financial institutions and traders should closely monitor political developments in order to better predict the CDS premia.