Explanation:
A limitation of using CDS as a measure of sovereign default risk is the potential for a thinly traded market. When the trading volume is low, it could lead to less reliable CDS spread data, which can affect its effectiveness in signaling true default probabilities.
A is incorrect. CDS pricing is observable through market data, although liquidity and trading volume can impact reliability.
C is incorrect. While CDS contracts may focus on shorter terms, they are still capable of reflecting long-term risk perceptions, especially when rolled over.
D is incorrect. Although CDS spreads can be influenced by global sentiments, this sensitivity is often integral to their role as real-time risk indicators.
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Q.5917 Using market-based indicators such as credit default swaps (CDS) to predict sovereign defaults can be insightful but are subject to specific limitations. What inherent characteristic of CDS might hinder their effectiveness as a standalone measure of country risk?
A
CDS pricing is not directly observable and is, therefore an unreliable measure of credit risk.
B
The CDS market is often thinly traded for sovereigns, making it difficult to infer reliable default risk signals from the spread data.
C
CDS contracts are exclusively based on short-term projections, providing a limited view of the sovereign's long-term default risk.
D
High sensitivity to global market sentiments might cause CDS spreads to deviate from the actual credit risk fundamentals of a sovereign.
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