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Measuring Contagion-Induced Funding Liquidity Risk in Sovereign Debt Markets

Author

Listed:
  • Cho-Hoi Hui

    (Hong Kong Monetary Authority)

  • Chi-Fai Lo

    (The Chinese University of Hong Kong)

  • Xiao-Fen Zheng

    (The Chinese University of Hong Kong)

  • Tom Fong

    (Hong Kong Monetary Authority)

Abstract

The euro-area sovereign debt crisis demonstrated how liquidity shocks can build up in a sovereign debt market due to contagion. This paper proposes a model based on the probability density associated with the dynamics of sovereign bond spreads to measure contagion-induced systemic funding liquidity risk in the market. The two risk measures with closed-form formulas derived from the model, are (1) the rate of change of the probability of triggering a liquidity shock determined by the joint sovereign bond spread dynamics of the systemically important countries (i.e., Italy and Spain) and small country (i.e., Portugal); and (2) the distress correlation between bond spreads, which can provide forward-looking signals of such risk. A signal of the rate of change of the joint probability appeared in April 2011 before the liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes. The empirical results show that when funding cost, risk aversion and equity prices pass through certain levels, the rate of change of the joint probability will rise sharply.

Suggested Citation

  • Cho-Hoi Hui & Chi-Fai Lo & Xiao-Fen Zheng & Tom Fong, 2015. "Measuring Contagion-Induced Funding Liquidity Risk in Sovereign Debt Markets," Working Papers 182015, Hong Kong Institute for Monetary Research.
  • Handle: RePEc:hkm:wpaper:182015
    as

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    References listed on IDEAS

    as
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    More about this item

    Keywords

    European Sovereign Debt Crisis; Liquidity Risk; Contagion;
    All these keywords.

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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