An Analysis of Sovereign Credit Risk Premia in the Euro Area: Are They Explained by Local or Global Factors?
35 Pages Posted: 28 May 2020
Date Written: March 18, 2020
We study the determinants of sovereign credit risk in the euro area in a time period that includes the financial and sovereign debt crisis, as well as the unconventional monetary policy adopted by the European Central Bank. First, we detect the presence of commonality in sovereign credit spreads of different countries, justifying the search for the common factors that drive CDS prices. Building on the work of Longstaff et al. (2011), we employ the econometric model used in Cecchetti (2017) to decompose sovereign credit default swap spreads into expected default losses and risk premia, finding evidence of a significant contribution of the latter component. We use the model to understand to what extent the variations in CDS spreads and in the two embedded components of selected euro-area countries are more linked to local or euro area economic variables. The results point to the importance of both global and local factors, which have a greater impact on the risk premium component. Finally, we estimate the contribution of the objective probability and risk premium components of redenomination risk (as measured by the ISDA basis) to the related CDS spread components, detecting some differences between countries.
Keywords: bond excess return, credit default swap, distress risk premium, credit losses
JEL Classification: B26, C02, F30, G12, G15
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