FORECASTING SOVEREIGN CDS PRICES

Abstract

Akey question in forecasting term structures of interest rates and credit spreads is the need and merit of using pricing models that impose absence of arbitrage across di erent maturities. This paper addresses this question in forecasting the CDS prices of nineteen major and diverse sovereigns. Arbitrage-free a ne pricing models forecast future term structures of sovereign CDS prices better than arbitrage-prone popular dynamic Nelson-Siegel (DNS) forecasting models. This is the case for both one-week and one month forecast horizons. A ne pricing models outperform because they are arbitrage-free and often have more exibility to closely match the present term structure of CDS prices. Simple autoregressions best forecast CDS prices at the one-week forecast horizon, because they perfectly match the present term structure of CDS prices but produce the worst forecasts at the one-month horizon.