The Impact of Distressed Economies in the EU Sovereign Market

Abstract

Financially distressed economies inside the European Union (EU) are blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within EU countries using the information content in the sovereign CDS market. We proceed in two directions: first, we test the existence of cross-border volatility effects between central and peripheral EU countries. Second, we explore the effect of distressed economies on default and risk premium constituents of sovereign default swaps. We show a significant volatility spillover from distressed to central European Economic and Monetary Union (EMU) economies. This causality pattern leads to a significant impact on default swap risk premia. On average, risk premium accounts for around 25% of central EMU spreads, doubling for those countries outside the EMU. Peripheral risk also affects the default component of central economies, although its impact is lower.