Conditional Probabilities for Euro area Sovereign Default Risk

by André Lucas of VU University Amsterdam & Duisenberg School of Finance,
Bernd Schwaab of European Central Bank, and
Xin Zhang of VU University Amsterdam & Tinbergen Institute

June 28, 2012

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.

JEL Classification: C32, G32.

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

Previously titled: Conditional Probabilities and Contagion Measures for Euro Area Sovereign Default Risk

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