Sovereign risk contagion in the Eurozone: a time-varying coefficient approach

Ludwig, Alexander (2013): Sovereign risk contagion in the Eurozone: a time-varying coefficient approach.

Abstract

This paper analyzes sovereign risk contagion in the Eurozone using an extension to the canonical model for contagion proposed by Pesaran and Pick (2007) and Metiu (2012) to allow for time-varying coefficients. This becomes necessary due to changes in the risk pricing of sovereign bonds since the onset of the recent crisis period and due to the presence of contagion in typically bounded time intervals. Controlling for changes in the risk pricing by investors, we detect several channels of pure contagion between 2008 and 2012. Further, we find that the bailout-programs for Greece, Ireland and Portugal led to a disruption in contagion of sovereign risk from these countries to Spain, Italy, France and Belgium as was desired by policymakers. For all countries considered, we observe an increase in the relevance of general risk aversion towards sovereign debt since May 2010. This development partially replaced the significance of country-specific credit risk factors in explaining bond yield spreads. Our model extension yields a device that is suitable to determine whether policy interventions are required and to judge their success ex-post.

• Item Type: MPRA Paper
• Language: English
• Keywords: contagion; credit events; Eurozone; financial crisis; sovereign risk; time-varying approach
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems; G - Financial Economics > G0 - General > G01 - Financial Crises; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

References

Afonso, A., Furceri, D., Gomes, P., 2012. Sovereign credit ratings and financial markets linkages: application to European data, Journal of International Money and Finance 31, 606-638.

Arezki, R., Candelon, B., Sy, A., 2011. Sovereign Rating News and Financial Market Spillovers: Evidence from the European Debt Crisis, Working Paper No. 11/68, International Monetary Fund, Washington D.C.

Arghyrou, M. G., Kontonikas, A., 2012. The EMU sovereign-debt crisis: Fundamentals, expectations and contagion, Journal of International Financial Markets, Institutions and Money 22, 658- 677.

Aßmann, C., Boysen-Hogrefe, J., 2009. Determinants of government bond spreads in the euro area in good times as in bad. Kiel Working Paper 1548, Kiel Institute for the World Economy.

Barrios, S., Iversen, P., Lewandowska, M., Setzer, R., 2009. Determinants of intra-euro area government bond spreads during the financial crisis, European Economy - Economic Papers 388, European Commission.

Beber, A., Brandt, M., Kavajecz, K., 2009. Flight-to-quality or ight-to-liquidity? Evidence from the Euro-Area bond market, The Review of Financial Studies 22, 925-957.

Beirne, J., Fratzscher, M., 2013. The pricing of sovereign risk and contagion during the European sovereign debt crisis.,Journal of International Money and Finance 34, 60- 82.

Bernoth, K., Erdogan, B. 2010. Sovereign bond yield spreads: A time varying coefficient approach, Journal of International Money and Finance 31, 639-656.

Blanco, R., Brennan, S., Marsh, I.W., 2005. An empirical analysis of the dynamic relationship between investment grade bonds and credit default swaps, Journal of Finance 60, 2255-2281.

Candelon, B., Colletaz, G., Hurlin, C., Tokpavi, S., 2011. Backtesting value-at-risk: a GMM duration-based test, Journal of Financial Econometrics 9, 314-343.

Christoffersen, P., 1998. Evaluating Interval Forecasts, International Economic Review 39, 841-862.

Codogno, L., C. Favero, Missale, A., 2003. Yield Spreads on EMU Government Bonds, Economic Policy 18, 505-532.

Dornbusch, R., Park, Y.C., Claessens, S., 2000. Contagion: understanding how it spreads, World Bank Research Observer 15, 177-197.

Dufour, J., 2006. Monte Carlo Tests with Nuisance Parameters: A General Approach to Finite Sample Inference and Nonstandard Asymptotics, Journal of Econometrics 127, 443-477.

Elliott, G., T.J. Rothenberg, Stock, J. H., 1996. Efficient tests for an autoregressive unit root, Econometrica 64, 813-836.

Favero, C., Pagano, M., von Thadden, E.L., 2010. How does liquidity affect government bond yields?, Journal of Financial and Quantitative Analysis 45, 107-134.

Forbes, K., Rigobon, R., 2002. No contagion, only interdependence: measuring stock market co-movement, Journal of Finance 57, 2223-2261.

Gerlach, S., Schulz, A., Wolff, G. B., 2010. Banking and sovereign risk in the euro area, Discussion paper series 1: Economic studies, Deutsche Bundesbank, Research Centre.

Giordano, R., M. Pericoli, Tommasino, P., 2013. Pure or wake-up call contagion? Another look at the EMU sovereign debt crisis, Banca di Italia Working Paper.

Kalbaska, A., Gatkowski, M., 2012. Eurozone sovereign contagion: Evidence from the CDS market (2005-2010), Journal of Economic Behaviour and Organization 83, 657- 673.

Karmann, A., Maltritz, D., 2012. Sovereign Default Risk and Recovery Rates: What Government Bond Markets Expect for Greece, Review of International Economics 20, 723-739.

Kelejian, H.H., 1971. Two-stage least squares and econometric systems linear in parameters but nonlinear in the endogenous variables, Journal of the American Statistical Association 66, 373-374.

Kianifard, F., Swallow, W.H., 1996. A review of the development and application of recursive residuals in linear models, Journal of the American Statistical Association 91, 391-400.

Lee, J., Strazicich, M. C., 2003. Minimum LM unit root test with two structural breaks, The Review of Economics and Statistics 85, 1082-1089.

Leschinski, C., Bertram, P., 2013. Contagion dynamics in EMU government bond spreads, Leibniz University Hannover, Germany, Working Paper.

Longstaff, F., Mithal, S., Neis, E., 2005. Corporate yield spreads: Default risk or liquidity? New evidence from the credit default swap market, Journal of Finance 60, 2213-2253.

Lumsdaine, R.L., Ng, S., 1999. Testing for ARCH in the presence of a possibly misspecified conditional mean, Journal of Econometrics 93, 257-279.

Maltritz, D., 2012. Determinants of sovereign yield spreads in the Eurozone: a Bayesian approach, Journal of International Money and Finance 31, 657-672.

Metiu, N., 2012. Sovereign contagion risk in the eurozone, Economics Letters 117, 35-38.

Mink, M., De Haan, J., 2013. Contagion during the Greek Sovereign Debt Crisis, Journal of International Money and Finance 34, 102-113.

Missio, S., Watzka, S., 2011. Financial Contagion and the European Debt Crisis. CESifo, Munich, Germany. Working Paper No. 3554.

Newey, W. K., West, K. D., 1994. Automatic lag selection in covariance matrix estimation, Review of Economic Studies 61, 631-653.

Perron, P., 2006. Dealing with Structural Breaks. In Palgrave Handbook of Econometrics (Patterson, K., and Mills, T.C., eds), 278-352.

Pesaran, M.H., Pick, A., 2007. Econometric issues in the analysis of contagion, Journal of Economic Dynamics and Control 31, 1245-1277.

von Hagen, J., Schuknecht L., Wolswijk, G., 2011. Government Bond Risk Premiums in the EU Revisited: The Impact of the Financial Crisis, European Journal of Political Economy 27, 36-43.

Wing Fong, T., Wong, A., 2012. Gauging potential sovereign risk contagion in Europe, Economics Letters 115, 496-499.