Sovereign Contagion in Europe: Evidence from the CDS Market

This paper addresses the following questions. Is there evidence of nancial contagion in the Eurozone? To what extent a country's vul- nerability to contagion dep ends on fundamentals as opp osed the gov-ernment's credibility? We lo ok at the empirical evidence on Europeansovereigns CDS spreads and estimate an econometric mo del where a crucial role is played by time varying parameters. We mo del CDS spreadchanges at country level as reecting three dierent factors: a Global sovereign risk factor, a Europ ean sovereign risk factor and a Financial intermediaries risk factor. Our main ndings are as follows. First, Unlike the US subprime crisis which aected all Europ ean sovereign risks, the Greek crisis is largely a matter concerning the Euro Zone. Second, dierences in vulnerability to contagion within the Eurozone are even more remarkable: the core Eurozone memb ers b ecome less vulnerable to EUZ contagion, p ossibly due to a safe-heaven eect, while peripheric countries b ecome more vulnerable. Finally, market fundamentals go a long way in explaining these dierences: they jointly explainbetween 54 and 80% of the cross-country variation in idiosyncratic risks and inthe vulnerability to contagion, largely supp orting the wake-up call hyp othesis according to which market participants become more wary of market fundamentals during financial crises