A Revisit to Sovereign Risk Contagion in Eurozone with Mutual Exciting Regime-Switching Model
43 Pages Posted: 15 Sep 2022 Last revised: 11 Nov 2022
Date Written: August 29, 2022
This paper proposes a new mutual exciting regime-switching model where crises can spread contagiously across countries. Each country has its own hidden stochastic process that determines whether it is in a normal or crisis regime. The mutual-excitation component allows interactions in the Markov chains, and a crisis in one country could increase the likelihood of a crisis in another country. Using this new approach, I revisit the sovereign risk contagion in the euro area. I find striking shifts in market pricing functions for the sovereign bond spreads. Multi-country contagion plays a dominant role in driving such shifts, while common risk factors and country-specific fundamentals are less important.
Keywords: Contagion, Interdependence, Regime-switching, Mutual-excitation, Sovereign credit risk
JEL Classification: C24, C58, F36, G12, G15
Suggested Citation: Suggested Citation