The Dynamic Progression of the Redenomination and Sovereign Risk in the Price Discovery Process of Italian Banks’ CDSs

Abstract

The recent global financial crisis and the subsequent sovereign debt crisis of the Eurozone peripheral countries have generated historic levels of volatility and instability in the financial markets. In particular, during the sovereign debt crisis market operators have begun to focus on the so-called “redenomination risk”, that is the hypothesis of exit from the EMU (Euro Monetary Union) by one or more countries and the consequent redenomination of their debt in the past national currency. This type of risk constitutes a form of additional credit risk premium due to expected systemic failure of the Eurozone. The effects of the economic-financial crisis, the weak economic growth and the political instability that have characterized especially the Italian system in recent years provide the ideal starting point to analyze the evolution of the redenomination risk in the pricing process of the Italian banks’ CDSs (Credit Default Swaps). The contribution of this work is to evaluate the dynamic evolution of sovereign and redenomination risk in the price discovery process of the Italian banks’ CDS spreads (or premia) by using rolling window regressions. Results show that redenomination risk explains a great part of the variance in the CDS spreads during periods of financial distress. The sovereign risk component explains a large part of the variance for almost the entire considered period. JEL Classification: G01, G12, G14, G20. Keywords: CDS spreads, Sovereign risk, Redenomination risk, Rolling window regressions, ISDA basis.