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Nonlinearities in sovereign risk pricing the role of cds index contracts

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Listed:
  • Anne-Laure Delatte

    (Pôle Finance Responsable - Rouen Business School)

  • Julien Fouquau

    (NEOMA BUSINESS SCHOOL)

  • Richard Portes

    (CEPR)

Abstract

Is the pricing of sovereign risk linear during bearish episodes? Or can initial shocks on economic fundamentals be exacerbated by endogenous factors that create nonlinearities? We test for nonlinearities in the sovereign bond market of European peripheral countries during the debt crisis and explain them. Our estimates based on a panel smooth threshold regression model during January 2006 to September 2012 show four main findings: 1) Peripheral sovereign spreads are subject to significant nonlinear dynamics. 2) The deterioration of market conditions for financial names changes the way investors price risk of the sovereigns. 3) The spreads of European peripheral countries have been priced above their historical values, given fundamentals, because of amplification effects. 4) Two CDS indices on financial names unambiguously stand out as leading drivers of these amplification effects.

Suggested Citation

  • Anne-Laure Delatte & Julien Fouquau & Richard Portes, 2014. "Nonlinearities in sovereign risk pricing the role of cds index contracts," Sciences Po publications 2014-08, Sciences Po.
  • Handle: RePEc:spo:wpmain:info:hdl:2441/6b3bdv9unt9mspi3ri2ff917d6
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    1. repec:cii:cepiei:2015-q1-141-4 is not listed on IDEAS
    2. Hacioglu Hoke, Sinem & Kapetanios, George, 2017. "Common correlated effect cross-sectional dependence corrections for non-linear conditional mean panel models," Bank of England working papers 683, Bank of England.
    3. Aristei, David & Martelli, Duccio, 2014. "Sovereign bond yield spreads and market sentiment and expectations: Empirical evidence from Euro area countries," Journal of Economics and Business, Elsevier, vol. 76(C), pages 55-84.
    4. Erce, Aitor, 2015. "Bank and sovereign risk feedback loops," Globalization and Monetary Policy Institute Working Paper 227, Federal Reserve Bank of Dallas.

    More about this item

    Keywords

    European sovereign crisis; Panel Smooth Threshold; Regression Models; CDS indices;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models

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