Estimating redenomination risk under Gumbel–Hougaard survival copulas

Abstract

We study the dependence between redenomination and default risk for Italy, France, Germany and the Netherlands exploiting the 2014 revision of ISDA CDS contract standard. For these countries redenomination has become a credit event under the new standard, while it was not so under the old standard. Both contracts are currently traded. Using MLE on transformed data we simultaneously estimate the dependence of the two risks and an unbiased measure of redenomination risk. The unbiased estimate unveils a feature common to all four countries. Redenomination risk has risen and remained above default risk since February 2017, when the U.K. Parliament officially approved the formal request to start the Brexit procedure. We find that after February 2017 the CDS market has mostly priced redenomination as the most likely outcome of the next sovereign crisis in the Euro area. Finally, we use a Marshall–Olkin approach to model the dependence of redenomation risk of the countries and to estimate a measure of the end of the Euro. The measure obtained is very close to the value of the German CDS, in support of the widespread market practice of using that contract as tail-hedge against end of the Euro.