Nonlinearities in Sovereign Risk Pricing: The Role of CDS Index Contracts

47 Pages Posted: 2 Jun 2014

See all articles by Anne-Laure Delatte

Anne-Laure Delatte

CNRS

Julien Fouquau

University of Orleans

Richard Portes

London Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2014

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.

Keywords: CDS indices, European sovereign crisis, Panel Smooth Threshold Regression Models

JEL Classification: C23, E44, F34, G12, H63

Suggested Citation

Delatte, Anne-Laure and Fouquau, Julien and Portes, Richard, Nonlinearities in Sovereign Risk Pricing: The Role of CDS Index Contracts (March 2014). CEPR Discussion Paper No. DP9898, Available at SSRN: https://ssrn.com/abstract=2444920

Anne-Laure Delatte (Contact Author)

CNRS ( email )

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Julien Fouquau

University of Orleans ( email )

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Richard Portes

London Business School - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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