Academic journal article International Journal of Business

Modeling Transmissions of Volatility Shocks: Application to CDS Spreads during the Euro Area Sovereign Crisis

Academic journal article International Journal of Business

Modeling Transmissions of Volatility Shocks: Application to CDS Spreads during the Euro Area Sovereign Crisis

Article excerpt

ABSTRACT

This paper tests empirically the contagion and the transmission mechanism of shocks in volatility between the peripheral Eurozone countries. We use the sovereign CDS spreads and the asymmetric model of dynamic conditional correlation GARCH DCC. We investigate the effects of positive and negative shocks over the long term. We investigate the systemic nature of the crisis in Europe. We implement testing of the non-linearity of propagation mechanisms of shocks through a long-term interdependence VECM model (Johansen co-integration). The generated results show that changes in the index of sovereign CDS have a very significant effect on changes in stock indexes in Europe. This is especially true in the case of Germany and France and the PIIGS countries.

JEL Classifications: C5, G15

Keywords: sovereign debt crisis; DCC GARCH; cointegration; transmission; volatility shocks

I. INTRODUCTION

In the last decade, adverse events have characterized the international financial sphere and in particular the Europe. Indeed, the subprime crisis had impacted financial markets in the world and also Europe, which is seen as the most affected. In 2010, economists start talking about a new outbreak of sovereign debt crisis in Greece. This country shows a growth rate of 4.2% recorded from 2000 to 2007 and became the most indebted country with a huge public debt reaching 152% in 2011. Greece officially began to suffer from the crisis of sovereign debt following the lowering of its sovereign credit rating.

The peripheral Eurozone countries have been affected following a fault overpayment. Thus, a new risk adds to the global economy: the sovereign debt crisis. This extends the global economy into recession, coupled with serious political and social issues. Economists are interested in studying the importance of contagion and its implications for the stability of financial markets. Missio and Watzka (2011) have estimated a model of dynamic conditional correlation (DCC) to analyze the correlation structure of Greek, Portuguese, Spanish, Italian, Dutch, Belgian and Austrian yield spreads bonds on the German yield study contagion in the euro zone. Alter and Beyer (2014) presented an empirical framework to quantify the spillovers. The study is based on technical standards VAR generalized impulse response functions to calculate the indices of infection in Spanish sovereign CDS shock. It shows a high impact on both sovereign CDS in the euro zone and banks during the first half of 2012 compared with 2011.

This article is based on an extension of this stream of the literature and fits into the same perspective. The goal is to test empirically the contagion as the transmission mechanism of shocks in volatility between the peripheral countries of the euro area, based on changes in sovereign CDS spreads. We analyze the transmission of shocks to sovereigns in those markets for the same country indices. We refer in the first time to the modeling of the conditional variance of GARCH multi varied (MGARCH) to empirically test the contagion of sovereign risk among the major countries of the European Union using sovereign CDS spreads. This model has the flexibility of univariate GARCH models associated with parsimonious parametric models for the correlations. The model allows reduction through heteroscedasticity responsible for the persistence of shocks to volatility and the overestimation of cross-correlations.

We present the concept of systemic risk with an empirical test. This allows to better understand its effects and testing transmission market sovereign shock to the financial system of Europe, via the cointegration model. Finally, we test the nonlinearity of propagation mechanisms of shocks estimated through a model of long-term interdependence VECM. The model is based on the cointegration test (Johansen test).

II. SOVEREIGN DEBT: FROM CRISIS TO CRISIS:

Sovereign debt is defined by Cohen (2012) as "all debts held by the State to its creditors who may be natural persons (companies, banks, individuals, etc. …

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