CDS and equity markets’ volatility linkages: lessons from the EMU crisis

We investigate the means and volatility feedback loop hypotheses in terms of the informational flow among credit distress conditions, equity market expectations and investor sentiment to identify the transmission channels among sovereign CDS, equity and volatility markets. We examine core (Germany, France) and periphery (Portugal, Italy, Ireland, Spain, Greece) EMU countries for the 2009–2014 period. Our findings support the volatility feedback loop hypothesis among markets. Specifically, the major transmitters of shocks (volatility) were both the core and periphery sovereigns, while investor sentiment was the main receiver of volatility. Further, we found that, before the EMU debt crisis (2008–2009), the information flow started from the equity towards the CDS market but turned bidirectionally, post-debt crisis (2010–2014). Finally, geopolitics as a measure of macroeconomic risk, was found to respond more to sovereign risk than to bank risk in the EMU, and to the core sovereign/bank risk than to the periphery.