The Econometrics of Redenomination Risk

Abstract

Redenomination and default risk are key issues for European sovereign bond markets. Which of the two credit events is more likely? And which is expected to occur first? For Italy, France, Germany and Netherlands we find that redenomination abruptly rises above default risk since February 2017, when the Brexit implementation procedure began. Since then, the CDS has almost only priced redenomination risk occurring before default. This is due to high dependence between redenomination and default risk. Dependence also implies that redenomination occurring first not only does not exclude default, but would dramatically increase default risk following redenomination. Simultaneous estimation of dependence and redenomination is obtained using a MLE on transformed data, tailored to the CDS problem. In a cross-section analysis we propose a measure of the end of the Euro, and we confirm that i) redenomination of Italy is mostly idiosyncratic (the Euro would most likely survive to Italy leaving); ii) the measure is very close to the German CDS that is commonly used in the tail-hedging market practice.

Keywords: Credit Default Swaps, Copula functions, Redenomination Risk, MLE on transformed data

JEL Classification: C01, C58, E44, F45, G01, G13