How Euro-Area Sovereign Spreads Respond to Shocks? A TVP-FAVAR Model
38 Pages Posted: 15 Sep 2013
Date Written: September 13, 2013
Abstract
This paper examines the underlying dynamics of the Euro-area sovereign bonds most in need of fiscal consolidation by employing a Bayesian time varying parameter factor augmenting VAR (TVP-FAVAR thereafter) model. This methodology is applied for the first time and allows multivariate stochastic volatility. By doing so we identify the underlying response of Euro-area sovereign bonds spreads to shocks in several important factors, and in particular debt dynamics and credit risk. Deteriorating fiscal conditions appear to be the driving force behind high sovereign spreads and CDS. Significant evidence of volatility spikes in the sovereign debt markets is identified. The present study entails important implications for policy makers and enhances our understanding of market pricing mechanisms of default risk.
Keywords: credit risk, TVP-FAVAR, sovereign debt crisis, spreads, CDS
JEL Classification: G00, G01
Suggested Citation: Suggested Citation