Common Risks in the Eurozone
52 Pages Posted: 21 Oct 2014 Last revised: 21 Dec 2015
Date Written: April 28, 2015
We construct a single consistent jump diffusion model with stochastic volatility which incorporates a common Eurozone shock factor to value currency, interest and sovereign debt products in European financial markets. In the model sovereign defaults can be induced either by the common Eurozone shock factor or by country idiosyncratic credit events. The Eurozone shock factor additionally induces a jump in the EUR/USD currency and thus creates a direct codependence between debt and currency markets. We use the model to price Eurozone sovereign CDS contracts and EUR/USD FX options between 2009 and 2014. Our findings suggest that changes in Eurozone shock risk can explain a significant proportion of the variation in EUR/USD volatility skews. The factor also plays an important role in the valuation of Eurozone sovereign CDS contracts. We find further that the Eurozone shock factor as well as idiosyncratic default risks heavily influence FX dynamics, and constitute statistically and economically significant excess return components. We further find a positive market price of (common) Eurozone shock risk.
Keywords: Currency risk, sovereign default risk, Bayesian analysis
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