Conditional Probabilities for Euro Area Sovereign Default Risk

Tinbergen Institute Discussion Paper No. 11-176/2/DSF29

37 Pages Posted: 14 Dec 2011 Last revised: 29 Jun 2012

See all articles by Andre Lucas

Andre Lucas

Vrije Universiteit Amsterdam; Tinbergen Institute

Bernd Schwaab

European Central Bank (ECB) - Directorate General Research

Xin Zhang

Sveriges Riksbank - Research Division; BIS Innovation Hub

Date Written: December 13, 2011

Abstract

We propose a novel empirical framework to assess the likelihood of joint and conditional failure for Euro area sovereigns. Our model is based on a dynamic skewed-t copula which captures all the salient features of the data, including skewed and heavy-tailed changes in the price of CDS protection against sovereign default, as well as dynamic volatilities and correlations to ensure that failure dependence can increase in times of stress. We apply the framework to Euro area sovereign CDS spreads from 2008 to mid-2011. Our results reveal significant time-variation in risk dependence and considerable spill-over effects in the likelihood of sovereign failures. We also investigate distress dependence around a key policy announcement by Euro area heads of state on May 9, 2010, and demonstrate the importance of capturing higher-order time-varying moments during times of crisis for the correct assessment of interacting risks.

Keywords: sovereign credit risk, higher order moments, time-varying parameters, financial stability

JEL Classification: C32, G32

Suggested Citation

Lucas, Andre and Schwaab, Bernd and Zhang, Xin (Kelvin), Conditional Probabilities for Euro Area Sovereign Default Risk (December 13, 2011). Tinbergen Institute Discussion Paper No. 11-176/2/DSF29, Available at SSRN: https://ssrn.com/abstract=1971705 or http://dx.doi.org/10.2139/ssrn.1971705

Andre Lucas (Contact Author)

Vrije Universiteit Amsterdam ( email )

SBE/EDS, De Boelelaan 1105
Amsterdam, 1081 HV
Netherlands
+31 20 598 6039 (Phone)
+31 20 598 6020 (Fax)

HOME PAGE: http://personal.vu.nl/a.lucas

Tinbergen Institute

Roetersstraat 31
Amsterdam, 1018 WB
Netherlands

HOME PAGE: http://www.tinbergen.nl

Bernd Schwaab

European Central Bank (ECB) - Directorate General Research ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany

Xin (Kelvin) Zhang

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden

BIS Innovation Hub

Mäster Samuelsgatan 36
Stockholm, 111 57
Sweden

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