A Structural View of Sovereign Risk Contagion in the Euro Zone

Abstract

This paper explores the impact of the European debt crisis on the valuation of sovereign debt in the euro area in a structural model that merges a sovereign country's stock market, CDS market, and its national finances. By estimating the model over the period from July 2007 to April 2012 using CDS data, this study reveals a structural break in the valuation of sovereign debt at the beginning of the European debt crisis. While for core euro-area countries this structural break takes the form of an upward shift of their default barriers that corresponds to an upward shift of their market implied or implicit debt levels, a downward shift is observed for a set of peripheral euro-area countries. These findings are consistent with markets pricing in guarantees and bailout payments between core and peripheral euro-area countries.