Disentangling contagion among sovereign CDS spreads during the European debt crisis |
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| Institution: | 1. Department of Economics, Erasmus University Rotterdam, P.O. Box 1738, 3000DR, The Netherlands;2. Economics and Research Division, De Nederlandsche Bank, P.O. Box 98, 1000AB, The Netherlands;1. Xfi, Center for Finance and Investment, University of Exeter, Exeter, EX4 4PU, UK;2. University of Aberdeen Business School, Edward Wright Building, Dunbar Street, Aberdeen, AB24 3QY, UK;3. University of Edinburgh Business School, 29 Buccleuch Place, Edinburgh, EH8 9JS, UK;1. University of Valencia, Valencia, Spain;2. Cass Business School, City University London, UK;3. Public University of Navarre, Pamplona, Spain |
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| Abstract: | During the last crisis, developed economies' sovereign credit default swap (hereafter CDS) premia have gained in importance as a tool for approximating credit risk. In this paper, we fit a dynamic factor model to decompose the sovereign CDS spreads of ten OECD economies into three components: a common factor, a second factor driven by European peripheral countries and an idiosyncratic component. We use this decomposition to propose a novel methodology based on the real-time estimates of the model to characterize contagion among the ten series. Our procedure allows the country that triggers contagion in each period, which can be any peripheral economy, to be disentangled. According to our findings, since the onset of the sovereign debt crisis, contagion has played a non-negligible role in the European peripheral countries, which confirms the existence of significant financial linkages between these economies. |
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