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Euro at Risk: The Impact of Member Countries’ Credit Risk on the Stability of the Common Currency

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  • Bekkour, Lamia
  • Jin, Xisong
  • Lehnert, Thorsten
  • Rasmouki, Fanou
  • Wolff, Christian C

Abstract

In this paper, we empirically investigate the impact of the credit risk of Eurozone member countries on the stability of the Euro. In the absence of a common euro bond, euro-area credit risk is induced though the credit default swaps of the member countries. The stability of the euro is examined by decomposing dollar-euro exchange rate options into the moments of the risk-neutral distribution. We document that during the sovereign debt crisis changes in the creditworthiness of member countries have significant impact on the stability of the euro. In particular, an increase in member countries’ credit risk results in an increase of volatility of the dollar-euro exchange rate along with soaring tail risk induced through the risk-neutral kurtosis. We find that member countries’ credit risk is a major determinant of the euro crash risk as measured by the risk-neutral skewness. We propose a new indicator for currency stability by combining the risk-neutral moments into an aggregated risk measure and show that our results are robust to this change in measure. Noticeable is the fact that during the sovereign debt crisis, the creditworthiness of countries with vulnerable fiscal positions is the main risk-endangering factor of the euro-stability.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9229.

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Date of creation: Nov 2012
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Handle: RePEc:cpr:ceprdp:9229

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Keywords: credit default swaps; currency options; currency stability; European sovereign debt crisis; risk-neutral distribution;

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References

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  1. Graciela Laura Kaminsky, 1997. "Leading Indicators of Currency Crises," IMF Working Papers 97/79, International Monetary Fund.
  2. Dennis Bams & Thorsten Lehnert & Christian C. P. Wolff, 2009. "Loss Functions in Option Valuation: A Framework for Selection," Management Science, INFORMS, vol. 55(5), pages 853-862, May.
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  14. Gurdip Bakshi & Nikunj Kapadia & Dilip Madan, 2003. "Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options," Review of Financial Studies, Society for Financial Studies, vol. 16(1), pages 101-143.
  15. Jun Pan & Kenneth J. Singleton, 2008. "Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads," Journal of Finance, American Finance Association, vol. 63(5), pages 2345-2384, October.
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Cited by:
  1. Thorsten Lehnert & Yuehao Lin & Nicolas Martelin, 2013. "Stein s Overreaction Puzzle: Option Anomaly or Perfectly Rational Behavior?," LSF Research Working Paper Series 13-11, Luxembourg School of Finance, University of Luxembourg.

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