Sovereign Contagion in Europe: Evidence from the CDS Market

This paper addresses the following questions. Is there evidence of contagion in the Eurozone? To what extent do sovereign risk and the vulnerability to contagion depend on fundamentals as opposed to a country's 'credibility'? We look at the empirical evidence on EU sovereigns CDS spreads and estimate an econometric model where the crucial role is played by time varying parameters. We model CDS spread changes at country level as reecting three different factors: a Global sovereign risk factor, a European sovereign risk factor and a Financial intermediaries risk factor. Our main ndings are as follows. First, while the US subprime crisis affects all European sovereign risks, the Greek crisis is largely a matter concerning the Euro Zone. Second, differences in vulnerability to contagion in the Eurozone are remarkable: after the Greek crisis the core Eurozone members become less vulnerable to EUZ contagion, possibly due to a safe-heaven effect, while peripheric countries become more vulnerable. Third, market fundamentals go a long way in explaining these differences: they jointly explain between 54 and 80% of the cross-country variation in idiosyncratic risks and in the vulnerability to contagion, largely supporting the 'wake-up calls' hypothesis suggesting that market participats bocome more wary of market fundamentals during finacial crises.