Abstract
This paper explores systemic risk spillovers between sovereign credit default swaps (CDS) returns in Europe during the period 2006–2016. We model spillovers using a spatial regression approach that allows us to analyze the effects of the movements of CDS returns in terms of spillovers and externalities. The spatial model decomposes the CDS returns into a systemic, systematic and idiosyncratic risk premium. We perform also stress testing to capture the impact of extreme events on CDS portfolios. Our results reveal significant impact of systemic risk spillover on sovereign CDS in Europe. Using Monte Carlo simulation, we show that spillovers between CDS markets increase the risk of CDS portfolios and the risk increases for high spatial interconnectivity between sovereign markets.
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Notes
LM-Lag and LM-Error statistics used in this paper are initially discussed by Anselin et al. (1996) and measured as follows:
$$\begin{aligned} & {\text{LM-Lag}} = \frac{{\left( {\frac{{{\hat{\varvec{\upvarepsilon}}}^{\prime} {\mathbf{Wy}}}}{{\hat{\sigma}_{\varepsilon }^{2} }}} \right)^{2} }}{B}\sim\chi^{2} (1) \\ & {\mathbf{W}} = {\mathbf{I}}_{T} \otimes W,\quad \hat{\sigma }_{\varepsilon }^{2} = {\hat{\varvec{\upvarepsilon }}}^{\prime } {\hat{\varvec{\upvarepsilon }}}/{\text{NT}},\quad {\hat{\varvec{\upvarepsilon }}} = {\mathbf{y}} - {\mathbf{X}}{\hat{\varvec{\upbeta }}} \\ & B= \left[ {\left( {{\mathbf{W}}\hat{y}} \right)^{\prime } {\mathbf{M}}\left( {{\mathbf{W}}\hat{y}} \right)/\hat{\sigma }_{\varepsilon }^{2} } \right] + T.trace\left( {WW + W^{\prime } W} \right) \\ & {\text{LM-Error}} = \frac{{\left( {\frac{{{\hat{\varvec{\upvarepsilon }}}^{\prime } \left( {{\mathbf{I}}_{T} \otimes W} \right){\hat{\varvec{\upvarepsilon }}}}}{{\hat{\sigma }_{\varepsilon }^{2} }}} \right)^{2} }}{{T.trace\left( {WW + W^{\prime } W} \right)}}\sim\chi^{2} (1) \\ & {\hat{\varvec{\upvarepsilon }}} = {\mathbf{y}} - {\mathbf{X}}{\hat{\varvec{\upbeta },}}\quad \hat{\sigma }_{\varepsilon }^{2} = {\hat{\varvec{\upvarepsilon }}}^{{\prime }} {\hat{\varvec{\upvarepsilon }}}/{\text{NT}} .\\ \end{aligned}$$
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Mili, M. Systemic risk spillovers in sovereign credit default swaps in Europe: a spatial approach. J Asset Manag 19, 133–143 (2018). https://doi.org/10.1057/s41260-017-0068-1
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DOI: https://doi.org/10.1057/s41260-017-0068-1