Sovereign Contagion in Europe: Evidence from the CDS Market

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1 Sovereign Contagion in Europe: Evidence from the CDS Market Paolo Manasse*, Luca Zavalloni** Bologna University*,Warwick University** Copenhagen Business School, Copenhagen, September 23, 2013

2 Plan of the talk 1. Questions and Answers 2. Methodology 3. Data 4. Results

3 1.Questions Is there evidence of contagion in sovereign CDS in the Eurozone during the recent crises? (Subprime, Greece) What s the role of economic fundamentals in explaining changes in (CDS) spreads? Is it different in crisis time? (Wake up call?) Does the Euro protect from or expose to contagion? - Politics ( are not Greece ) - Economics (Multiple vs Unique Equilibria, Runs &Sunspots, Global Games)

4 Answers Fundamentals: account (54-80%) of countries vulnerability to contagion and idiosyncratic risks Wake up Call: fundamentals matter a lot more during crisis - Solvency indicators (debt GDP ratio) - real economy (the rate, the rate of unemployment) matter (more) in crisis - Credit ratings Euro membership: was a shield in normal times, becomes a source of vulnerability in Greek crisis Asymmetry Core/Periphery France, Belgium and PIIGS (Italy, Spain, Ireland and Portugal) large and recurrent spikes in contagion and idiosyncratic risk, core do not

5 An Italian Detour: Fundamentals Matter? The puzzle is why spread did not rise before!

6 Contagion and idiosyncratic risk / = / ( ) = Large literature since King,Sentana and Wadwahani (1990). Here Bakaert et al. (2011)

7 2. Methodology: Capital Asset Pricing Model (Arbitrage Pricing Theory), with time-varying parameters Δsit = daily change in the CDS spread (price of insurance against default) of sovereign in country i at time t Ft = vector of common factors, un-diversifiable risk (market return in CAPM), source of inter-dependence FG= Global Sovereign CDS index FE = European Sovereign CDS Index, FF = Financial CDS Index (banks insurance companies default risks) βit = contagion parameters αit = Jensen alpha, abnormal idiosyncratic return, drift of the CDS spread daily change of country i at time t εit = residual (assumed uncorrelated among i s)

8 Zi = vector of macro-variables of country i CR= Crisis Dummy EUZ = Eurozone Membership dummy Eqs (3)-(4): Fundamentals (Z), Crisis (CR), and EUZ affect drift (idyosyncr,alpha) and sensitivity (contagion, beta) to global, european and financial risks Eqs (5)-(6): Fundamentals and Eurozone affect the impact of the Crisis on drift and sensitivity («Wake up Call effect)

9 Two Step Procedure 1. Estimate CAPM eq. 2 for Δsit - Country by country (15 European, 4 non Euro) - Time-varying coefficients: rolling window of 200 daily observations (out of 1640), princ components construction of F s, orthogonalization, L=5, 1430 regressions per country 2. Recover time varying parameters αit, βit (1430 parameters for each country) - assign them to last day of each window, - Stack them up for the 15 countries as dependent variables in a system of eqs - Estimate panel of eqs(3)-(6) (on weekly averages)

10 Data & Variables dependent variables Spreads on CDS contract : liquid market Bomm (2005) incorporate information more quickly than bond markets. Sample period : 1 January 2006 to 29 march daily observations: 15 European sovereign CDS spreads. 11 Euro zone (Germany, France, Italy, Spain, Belgium, Greece, Portugal, Ireland, Netherland, Austria, Finland), 4 outside EUZ (Sweden, Norway, UK and Northern Ireland, Denmark). Source: Data on CDS have been collected from Datastream by Thomson Reuters.

11 Data & Variables Explanatory Variables FG = index of Global (non-european) sovereigns CDS built from Markit itraxx SovX Global Liquid Investment Grade Index (comprising the most liquid high grade sovereign entities around the globe) FE = an index of Western European sovereigns CDS built from the Markit itraxx SovX Western Europe Index (comprising 11 members of the Eurozone1 plus Denmark, Norway, Sweden and United Kingdom) FF = index of CDS on private European Financial Institution, Markit itraxx European Senior Financials Index (comprising 25 major financial institutions in Europe)

12 Index contruction

13 Construction of Risk Indexes (Global, European, Financial) 1. Take basket of CDS spreads 2. Calculate Principal Components for each rolling window 3. Normalize factor weights to sum to 1 for each window pc is the linear combination which max total variance (instead of fixed weights) 4. Othogonalization: Global Sovereign Risk Index - European Sovereign Risk Index - Financial Institutions Risk Index - remove endogeneity, collinearity, spurious correlations (robustness done for different ordering) - Indexes are country specific (e.g. each European country in turn is excluded from it s own European index)

14 Data & Variables (2nd stage) Dummy Greek Crisis: November 2009 onward (deficit revision), robustness analysis: April 2010 (S&P junk status). Macro country-specific variables: public debt/gdp ratio, budget deficit/gdp ratio current account balance/gdp change in industrial production sovereign rating (Moody s): conversion and innovation trade openness VIX Index (Chicago Board Options Exchange Market Volatility Index) TED spread (the difference between the three-month LIBOR and the three-month T-bill interest rate)

15 4.Results: α it Smalls

16 MEDIUMS

17 Larges

18 1. Idiosyncratic Risk: three sizes - Small (Finland, Germany and Norway), - Medium (Sweden, Denmark, the Netherlands, Belgium, France, the UK, and Austria on the high side) and -Large (the periphery: Spain, Italy, Ireland Portugal, Greece). 2. US subprime affect all Europeans (mostly UK, IRL, Aus), while Greek crisis is a matter for Eurozone (Nor, Swe, Dan,UK not affected). 3. Differences inside the Eurozone are at least as remarkable, with France, Belgium, Italy, Spain, Ireland and Portugal most affected Timing: Ireland (bail-out Nov 2010, affected only in Dec 2010),Portugal (bail-out April 2011), Italy (problem in Sept 2011 )

19 4.Results: βgβeβf (contagion to sov global (red), sov european (blue) and financial risks (green) Core

20 4.Results: βgβeβf (contagion to sov global (red), sov european (blue) and financial risks (green) Periphery

21 Contagion evidence 1. Before Subprime Crisis (Sept 2008) no interdependence 2. Subprime Crisis: jump in European interdependence for all countries 3. Greek Crisis (Nov 2009): βe down in Core, βe up in Periphery (safe heaven) 4. βg overtakes βe in mid βf rises since early 2011

22 Step 2: Explaining Idyosyncratic Vulnerability (alphas)

23 Normal times (before Greek Crisis): only growth i.p, deficit, VIX matter Inside Crisis: fundamentals matter much more (unemployment, growth, debt, deficit) Credit Ratings matter Eurozone membership raise culnerability R2 (fundamentals) = 54%

24 Explaining Contagion vulnerability to European Sovereign Risk (betas Euro )

25 In normal times (before Greek crisis): Euro membership reduces contagion, debt, deficit, openness, VIX matter Inside Greek Crisis: Euro membership becomes handicap; unemployment, ip, debt, VIX matter more, deficit and opennes less R2 = 80%

26 Summary table

27 Conclusions Market fundamentals matter a lot more during crisis: Wake up call debt GDP ratio, the growth rate, the rate of unemployment, become larger/significant, Euro membership handicap Credit ratings become significant Fundamentals explain 54 60% cross country heterogeneity in idiosyncratic risk/ contagion Policy implications: beware of cold turkey effects on spreads

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