Working Paper: NBER ID: w19985
Authors: Annelaure Delatte; Julien Fouquau; Richard Portes
Abstract: Is the pricing of sovereign risk linear during bearish episodes? Or can initial shocks on economic fundamentals be exacerbated by endogenous factors that create nonlinearities? We test for nonlinearities in the sovereign bond market of European peripheral countries during the debt crisis and explain them. Our estimates based on a panel smooth threshold regression model during January 2006 to September 2012 show four main findings: 1) Peripheral sovereign spreads are subject to significant nonlinear dynamics. 2) The deterioration of market conditions for financial names changes the way investors price risk of the sovereigns. 3) The spreads of European peripheral countries have been priced above their historical values, given fundamentals, because of amplification effects. 4) Two CDS indices on financial names unambiguously stand out as leading drivers of these amplification effects.
Keywords: Sovereign Risk; CDS Index Contracts; Nonlinear Pricing; European Debt Crisis
JEL Codes: C23; E44; F34; G12; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Peripheral sovereign spreads (G19) | Nonlinear dynamics (C69) |
| Deterioration of market conditions for financial entities (E44) | Pricing of sovereign risk (F34) |
| Increased financial uncertainty (G19) | Higher sovereign spreads (F34) |
| Initial shocks to economic fundamentals (E32) | Amplification effects on spreads (C58) |
| CDS indices on financial names (G12) | Sovereign risk pricing (F34) |
| Changes in CDS indices (C43) | Changes in sovereign spreads (H63) |