Economic theory suggests that rising deficits, large levels of public debt, and weak economic performance are all possible consequences of economic policy uncertainty (EPU). High EPU may thus fuel uncertainty about solvency of a country and thereby drive up CDS volatility.
This paper examines whether EPU helps to explain the volatility of sovereign CDS spreads and considers sixteen economies: Germany, France, Italy, Spain, Netherlands, Ireland, Sweden, Great Britain, the US, Japan, Australia, China, Russia, South Korea, Brazil, and Chile.
The empirical results provide strong support for a positive link between EPU and sovereign CDS volatility. The results imply that 1% more EPU produces about 0.3% – 0.8% more sovereign CDS volatility. The paper also considers spillovers from US and European EPU to the CDS volatility of other countries. It turns out that US EPU affects foreign CDS volatility in many cases. European EPU has, in contrast, no important effect on the CDS volatility of other countries.