Sovereign Risk Zones in Europe During and After the Debt Crisis

Abstract

We employ a machine learning approach to build a European sovereign risk stratification using macroeconomic fundamentals and contagion measures, proxied by copula-based credit default swap (CDS) dependencies over the period 2008-2017, for France, Germany, Greece, Ireland, Italy, Portugal, and Spain. By adopting a recursive partitioning strategy we detect specific risk zones varying from safe to high risk based on key predictors, and we construct their specification by assigning specific risk thresholds. While key macroeconomic fundamentals such as Debt/GDP and the unemployment rate remained the same and maintained the same risk thresholds during (2008-2013) and after (2013-2017) the crisis, the CDS spreads contagion dropped significantly over the post-crisis years, lowering the corresponding risk thresholds. We estimate an impact on CDS spreads approximately of -150 basis points in the period 2013-2017 due to contagion mitigation.

Keywords: contagion, copula, credit default swaps, machine learning, regression trees, systemic risk

JEL Classification: C11, G01, G10