Sovereign debt sustainability and CDS returns
Selling protection through credit default swaps is akin to writing put options on sovereign default. Together with tenuous market liquidity, this explains the negative skew and heavy fat tails of generic CDS (short protection or long credit) returns. Since default risk depends critically on sovereign debt dynamics, point-in-time metrics of general government debt sustainability for given market conditions are plausible trading indicators for sovereign CDS markets and do justice to the non-linearity of returns. There is strong evidence of a negative relation between increases in predicted debt ratios and concurrent returns. There is also evidence of a negative predictive relation between debt ratio changes and subsequent CDS returns. Trading these seems to produce modest but consistent alpha.