The European Sovereign Debt Crisis and the Role of Credit Swaps

The global financial crisis of 2008–2009 that was triggered by the Lehman Brothers bankruptcy produced a liquidity problem in the shadow banking in the United States and a sovereign debt problem in Europe. The European financial crisis revealed that the European Monetary Union's (EMU) architectural deficiencies led to the increase of risk premia and poverty, especially for the South-West Euro-Area Periphery (SWEAP) countries.The main objectives of this research are to determine the factors responsible for the market pricing of sovereign default risk, to analyze the causalities of Credit Default Swaps (CDSs) spreads that have been taken as a proxy variable for the market pricing of sovereign default risk, to examine possible pricing discrimination and asymmetries between SWEAP and non-SWEAP (Not South-West Euro-Area Periphery) countries, structural changes in the pattern of the CDS spreads throughout and after the crisis, and possible evidence of speculation against the SWEAP group of countries.In a panel data regression setting, we have constructed a dynamic pricing model of sovereign default risk for 13 euro area countries using quarterly data for the period 2008–2013. We spotted structural changes in the pattern of CDS spreads across 2010, identified as the worst year of the Eurozone crisis, as well as significant speculation and financial discrimination against SWEAP countries by the financial intermediaries associated with this derivative market. Significant variables comprised of the grading rate forwarded one period, the current governments bond yield, and the inflation rate, as well as the variables related to the public debt lagged one period. All variables, amongst other robust predictors of the CDS spreads, have been proven statistically and were economically significant, except for the fiscal space of one quarter forward of the fiscal balance, which was proven to be only weakly significant. More specifically, the variables related to fiscal space (public debt and fiscal balance) as well as the inflation rate have been proven statistically significant throughout the global financial crisis (2008–2010) and the grading rate in the period 2011–2013. Nevertheless, the government's bond yield remained significant.The main limitation of this research was the endogeneity between bond and CDS-derivative markets, emerged from the latter variable. In total, our evidence of self-fulfilling expectations and herding behavior may indicate the logic of second generation crisis model for the crisis in Eurozone 2010.