Impacts of the financial crisis on eurozone sovereign CDS spreads

We study the variation of sovereign credit default swaps (CDSs) of eurozone countries, their persistence and co-movements, with particular attention given to the impact of the financial crisis. Specifically, using a dual fractional integration model, we test the evidence of long memory for CDSs of ten eurozone countries. Our analysis reveals that price discovery processes satisfy the minimum requirements for a weak form of efficiency for sovereign CDS markets, even during the crisis. In contrast, we document the spreading out of persistent CDS uncertainty among the peripheral economies with its outbreak. We provide evidence that CDS uncertainty has implications for the pricing of sovereign risk including that of core countries in the crisis period. Finally, we present the potential spillover effects utilizing a dynamic conditional correlation model and show that, with the collapse of Lehman, the probability of a contagion increased across all countries and became more explicit for peripheral economies as the sovereign crisis took on a new dimension.     

Network structures and idiosyncratic contagion in the European sovereign credit default swap market

This study combines conditional Granger causality and network analysis to examine the interconnectedness in the European sovereign credit default swap (CDS) market. We determine that the network is unstable in the short term and stable in the long term. Further, we visualize dynamic networks and confirm financial contagion in the 2012 European debt crisis. The sources of risk spillovers and the manner in which spillovers are transferred among countries are identified accordingly. Further, we conclude that interconnectedness can be a pricing factor for determining the sovereign CDS return. The results of the network analysis indicate that the European sovereign CDS market is a complex network system and can serve as a valuable reference for investors and policymakers.     

The anatomy of sovereign risk contagion

The channels for the cross-border propagation of sovereign risk in the international sovereign debt market are analysed. Identifying sovereign credit events as extraordinary jumps in CDS spreads, we distinguish between the immediate effects of such events and their longer term spillover effects. To analyse “fast and furious” contagion, we use daily CDS data to conduct event studies around a total of 89 identified credit events in a global country sample. To analyse “slow-burn” spillover effects, we apply a multifactor risk model, distinguishing between global and regional risk factors. We find that “fast and furious” contagion has been primarily a regional phenomenon, whilst “slow-burn” spillover effects can often be global in scope, especially those of the recent European debt crisis. The global risk factors are found to be driven by investor risk appetites and debt levels, whilst the regional factors depend on economic fundamentals of countries within a region.     

Cross country linkages and transmission of sovereign risk: Evidence from China’s credit default swaps

China’s climb to a trading powerhouse has changed its position in the world and therefore its relationships with other economies. As a result, its sovereign credit risk, which we measure by the pricing of its credit default swaps (CDS), now has the potential to greatly impact other sovereign CDS spreads. Employing a dynamic approach, we find that changes in China’s sovereign risk has strong contagion effects on its goods and service providers, while China is vulnerable to contagion effects from its major importers, suggesting sovereign risk spills over to other regions via the global supply chain. China’s success hurts some of the weaker countries in Europe by competing for their customers, while China faces strong competition itself from its export-focused neighbors. FDI and portfolio investment also affect the CDS relationships between China and other economies.     

主权CDS对欧元区主权债务危机的影响

本文概括了主权CDS是否影响欧元区主权债务危机的几种观点和研究,发现了其中的不足之处,并试图进行弥补。文章基于面板数据,在对样本区间和国家进行分组的基础上,用向量误差修正模型(VECM)检验了主权CDS息差与国债息差的价格发现过程,此外还用向量自回归(VAR)模型分析了各国主权CDS息差之间的传染效应。结果发现,虽然主权CDS在价格发现过程中占据领先地位,但是没有证据表明主权CDS与主权债务危机之间存在必然的联系,而各国债务危机之间确实存在传染效应。     

Factor decomposition of the Eurozone sovereign CDS spreads

In the present study, we examine the factors driving Eurozone sovereign credit default swap (CDS) spreads during the Eurozone sovereign debt crisis. For identifying factors we utilize independent component analysis (ICA), a technique similar to principal component analysis (PCA). We identify three factors that impact spreads and capture the features specific to the crisis such as the breakup risk of the Eurozone: peripheral factor, global factor, and Eurozone common factor. In contrast, when PCA is applied, only a single factor is identified. Moreover, using ICA with a GARCH model, we show that the source of volatility for CDS spreads shifted from the global factor in 2009 and the peripheral factor in 2010 to the Eurozone common factor in 2012, and that the dynamic correlation reflects the decoupling between low credit risk countries such as Germany and high credit risk countries such as Greece. We also show that the goodness-of-fit of the ICA-based model is better than other models used such as the Student's t copula model.     

Effect of the Sovereign Credit Ratings in East Asia Countries: Evidence from Panel Vector Autoregression

We study the effect of the sovereign credit ratings on the economies of seven East Asian countries, applying panel vector autoregression (VAR). We find that rating has less effect than outlook of rating on the credit default swap (CDS) spreads, the stock indexes, and the GDP growth rates. Rating upgrade and positive outlook have stronger effects than rating downgrade and negative outlook, and the effects of positive outlook and rating are greater after the financial crisis. There is evidence of contagion in that the economic variables of a country seem to have been affected by the outlooks of the other countries.     

The impact and the contagion effect of natural disasters on sovereign credit risk. An empirical investigation

This paper investigates the relationship between natural disasters and the reaction of sovereign CDS spread in Europe. By applying an event study methodology during the period January 2007–December 2021 on an original database in which we identify 92 natural disasters in 17 European countries, we assess the reaction of the sovereign CDS market to a natural disaster. We find a heterogeneous response of the European sovereign risk to a natural disaster, as the response of the sovereign CDS market differs from region to region. The advent of a natural disaster can increase inequality between the regions due to the higher cost of credit for sovereigns and the reduced scope for manoeuvring public finances. Also, the results of the contagion effect confirm the hypothesis of a cross-border propagation effect, as natural disaster, in general, is not local event but spreads to other countries.     

Sovereign Risk Contagion in East Asia: A Mixture of Time-Varying Copulas Approach

This study analyzes sovereign risk contagion between four East Asian economies (China, Hong Kong, Japan, and Korea) and its structural changes through the Global Financial Crisis (GFC) and the European Debt Crisis (EDC) by applying the mixture of time-varying copulas to those economies’ credit default swap (CDS) spreads.

This article first finds a strong contagion from the US and PIIGS economies to the East Asian sovereign CDS markets and intraregional contagion within the East Asian markets. Second, the impact of contagion is different according to whether it is measured by the linear (Gaussian) or the upper tail dependence. Third, Japan plays an important role in increasing the linear dependence whereas China and Korea are crucial in terms of the upper tail dependence. Lastly, the GFC has structurally increased the linear dependence but not the upper tail dependence between the East Asian sovereign CDS markets.     

Fear or fundamentals? Heterogeneous beliefs in the European sovereign CDS market

This paper proposes a model for credit default swap (CDS) spreads under heterogeneous expectations to explain the escalation in sovereign European CDS spreads and the widening variations across European sovereigns following the Global Financial Crisis (GFC). In our model, investors believe that sovereign CDS spreads are determined by country-specific fundamentals and momentum. By estimating the model we find evidence that, while some of the recent movements in sovereign CDS spreads can be explained by deteriorating fundamentals for core European Union (EU) countries, momentum has also played a destabilizing role since the GFC in all sovereign credit markets studied.     

Regime-Dependent Determinants of China’s Sovereign Credit Default Swap Spread

We study the determinants of China’s sovereign credit default swap (CDS) spread in a regime-switching framework. This framework allows us to identify potential cross-asset-class contagion from global financial markets to China. To avoid endogeneity biases coming from domestic costs of sovereign default, we model domestic financial indicators as endogenous variables and estimate the regime-switching model with instrumental variables. We find strong evidence of cross-asset-class contagion but no evidence of contagion from sovereign CDS markets of China’s major trade partners (the European Union, Japan, and the United States).     

The impact of the European sovereign debt crisis on banks stocks. Some evidence of shift contagion in Europe

This paper analyzes the influence of the recent European sovereign debt crisis on banks’ equity returns for 15 countries. Our data span the period December 14th 2007 - March 8th 2013 that encompasses several episodes of economic and financial turmoil since the collapse of the subprime credit market. Our contribution to the literature is twofold. First, we use an explicit multifactor model of equity returns extended with a sovereign risk factor. Second, we adopt a Smooth Transition Regression (STR) framework that allows for an endogenous definition of crisis periods and captures the changes in parameters associated with shift contagion. We find that the negative impact of the European sovereign debt crisis on banks’ equity returns has been mostly confined to European banks, whereas U.S. banks appear to be unharmed by its direct impact and may even have benefited from it. Besides, we find some evidence of shift contagion across Europe.     

Investor induced contagion during the banking and European sovereign debt crisis of 2007–2012: Wealth effect or portfolio rebalancing?

This study investigates the way a crisis spreads within a country and across borders by testing the investor induced contagion hypothesis through the liquidity channel on stock-bond relationships of the US and five European countries before and during the global banking and European sovereign debt crisis of 2007–2012. We provide evidence consistent with the wealth effect as a source of contagion for the majority of countries. Nevertheless, we uncover evidence of investor induced contagion sourced by the portfolio rebalancing effect for correlations involving Spanish and Italian bonds during the debt crisis. Further, we find that tight (narrow) credit spreads reduce (magnify) the wealth and portfolio rebalancing effects, which are offset by the opposite effects of risk aversion amongst investors, a dynamic that is not restricted to crisis periods.     

Is the Euro-zone on the Mend? Latin American examples to analyze the Euro question

Several European countries face challenges reminiscent of those faced by the emerging economies of Latin America. The economic booms in some peripheral Euro-zone countries financed by large capital inflows; the credit and asset price booms and then the busts including Sudden Stops in capital flows; the strong interaction between sovereign debt and domestic banking systems; the role of foreign banks and contagion; and all in the context of a fixed exchange rate, are familiar plotlines for Latin American audiences. For those Euro-zone countries that built up large Euro-denominated external liabilities, Latin America’s experience is particularly relevant and worrisome. Still, Europe may be in a better position to navigate a path out of the crisis given cooperative mechanisms that were absent in Latin America, particularly the availability of massive liquidity support. Nonetheless, while such support buys time, it does not guarantee success. This paper argues that reflecting on Latin America’s experience provides useful lessons for Europe to improve the chances for a successful resolution.     

How do global investors differentiate between sovereign risks? The new normal versus the old

When global investors go into emerging markets or get out of them, how do they differentiate between economies? Has this behavior changed since the crisis of 2008 to reflect a “new normal”? We consider these questions by focusing on sovereign risk as reflected in monthly returns on credit default swaps (CDS) for 18 emerging markets and 10 developed countries. Tests for breaks in the time series of such returns suggest a new normal that ensued around October 2008 or soon afterwards. Dividing the sample into two periods and extracting risk factors from CDS returns, we find an old normal in which a single global risk factor drives half of the variation in returns and a new normal in which that risk factor becomes even more dominant. Surprisingly, in both the old and new normal, the way countries load on this factor depends not so much on economic fundamentals as on whether they are designated an emerging market.     

Credit spread interdependencies of European states and banks during the financial crisis

We investigate the interdependence of the default risk of several Eurozone countries (France, Germany, Italy, Ireland, the Netherlands, Portugal, and Spain) and their domestic banks during the period between June 2007 and May 2010, using daily credit default swaps (CDS). Bank bailout programs changed the composition of both banks’ and sovereign balance sheets and, moreover, affected the linkage between the default risk of governments and their local banks. Our main findings suggest that in the period before bank bailouts the contagion disperses from bank credit spreads into the sovereign CDS market. After bailouts, a financial sector shock affects sovereign CDS spreads more strongly in the short run. However, the impact becomes insignificant in the long term. Furthermore, government CDS spreads become an important determinant of banks’ CDS series. The interdependence of government and bank credit risk is heterogeneous across countries, but homogeneous within the same country.     

Bank use of sovereign CDS in the Eurozone crisis: Hedging and risk incentives

Using a comprehensive dataset from German banks, we document the usage of sovereign credit default swaps (CDS) during the European sovereign debt crisis of 2008–2013. Banks used the sovereign CDS market to extend, rather than hedge, their long exposures to sovereign risk during this period. Lower loan exposure to sovereign risk is associated with greater protection selling in CDS, the effect being weaker when sovereign risk is high. Bank and country risk variables are mostly not associated with protection selling. The findings are driven by the actions of a few non-dealer banks which sold CDS protection aggressively at the onset of the crisis, but started covering their positions at its height while simultaneously shifting their assets towards sovereign bonds and loans. Our findings underscore the importance of accounting for derivatives exposure in building a complete picture and understanding fully the economic drivers of the bank-sovereign nexus of risk.     

The impact of distressed economies on the EU sovereign market

Financially distressed economies inside the European Union (EU) are being blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within the EU countries using the information content in the sovereign Credit Default Swap (CDS) market. We proceed in two directions. First, we test the existence of cross-border volatility effects between the central and the peripheral EU countries. Second, we explore the effect of distressed economies on the default and risk premium constituents of sovereign default swaps. We show a significant volatility spillover from distressed to central European Economic and Monetary Union (EMU) economies. This causality pattern leads to a significant impact on the default swap risk premia. On average, the risk premium accounts for approximately 42% of central EMU spreads and 56% of the spreads for those countries outside of the EMU. The peripheral risk also affects the default component of central economies, although its impact is lower.     

主权信用违约互换的运作及启示

欧洲各国主权债务危机的频发,使得主权CDS在全球范围内备受瞩目。本文分析了主权CDS的市场发展状况、运作及定价机制;考察欧洲主权债务危机中主权CDS的行为;提出对我国地方政府债务问题的启示。研究发现:(1)主权CDS息差变化受到了欧元区因素、本国因素、投机和代理对冲的影响;(2)短期主权CDS供不应求;(3)禁止主权CDS的裸卖空交易存在不合理性;(4)西欧主权风险外溢使得东欧及新兴市场国家的主权CDS市场波动加剧。     

Short-term determinants of the idiosyncratic sovereign risk premium: A regime-dependent analysis for European credit default swaps

This study investigates the dynamics of the sovereign CDS term premium, i.e. difference between 10Y and 5Y CDS spreads. It can be regarded a forward-looking measure of idiosyncratic sovereign default risk as perceived by financial markets. For some European countries this premium featured distinct nonstationary and heteroskedastic pattern during the last years. Using a Markov-switching unobserved component model, we decompose the daily CDS term premium of five European countries into two unobserved components of statistically different nature and link them in a vector autoregression to various daily observed financial market variables. We find that such decomposition is vital for understanding the short-term dynamics of this premium. The strongest impacts can be attributed to CDS market liquidity, local stock returns, and overall risk aversion. By contrast, the impact of shocks from the sovereign bond market is rather muted. Therefore, the CDS market microstructure effect and investor sentiment play the main roles in sovereign risk evaluation in real time. Moreover, we also find that the CDS term premium response to shocks is regime-dependent and can be ten times stronger during periods of high volatility.