Animal Spirits vs Contagion: Which one is the main driver of sovereign yields in Europe?

Our paper evaluates the relative importance of contagion and investors' risk aversion in determining sovereign debt yield during the fi nancial crisis in Europe. In the existing literature, pure contagion and investors risk aversion are often treated as indistinguishable, a possibly signifi cant conceptual shortcoming. In this paper we distinguish the impact of both variables on sovereign yields and clarify which had a more important role in the spread of financial crisis through Eurozone countries. We define risk aversion as the variations in the price of risk, extracted from the CDS spreads. Contagion, on the other hand, is defined as the increased probability of a bank defaulting given that another bank defaults. Default corresponds to the value of the asset value falling below a certain threshold, and the probability of default extracted from a probability density function estimated using CDS spreads. To test the impact of contagion and risk aversion on sovereign yields we employ a T-GARCH methodology to correct for the heteroscedasticity and to account for the fact that variance is asymmetrically dependent on the residuals. We fi nd that risk aversion, and not contagion, is the main culprit for the widening of yield spreads between South and Central European countries. The importance of risk aversion is con firmed by reactions to the Greek, Portuguese and Spanish bailouts.