Market-Based Sovereign Ceiling: Evidence fromthe European Sovereign Debt Crisis

Abstract

This article examines the impact of sovereign downgrades on European firms for equity and credit default swap (CDS) markets during the 2009–2012 period. The authors find evidence of spillover effects, where sovereign downgrades lead to negative abnormal stock returns and positive abnormal CDS spread changes for firms headquartered within the affected sovereign. The findings suggest the relevance of a market-based sovereign ceiling that could explain the observed risk spillover to debt and equity markets. The results supply confirmatory evidence of the relevance of a market-based sovereign ceiling in cross-sectional regressions and no evidence (as expected) for the relevance of a market-based sovereign ceiling for the safe-harbor sovereign—Germany. The authors also find that German firms, as safe-harbor firms, profit from downgrades of foreign sovereigns in terms of positive abnormal returns. <b>TOPICS:</b>Credit default swaps, credit risk management, developed