Volatility and mean spillovers between sovereign and banking sector CDS markets: a note on the European sovereign debt crisis

Abstract

This article empirically assesses causality-in-variance and causality-in-mean between the Eurozone banking sector Credit Default Swap (CDS) index and the Greek sovereign CDS spread. We employ the Cross-Correlation Function (CCF) approach developed by Hong (2001) to daily data from January 2008 to December 2011. Our key findings are twofold. First, before the European sovereign debt crisis, significant unidirectional causality-in-variance and causality-in-mean were found from the bank CDS to the Greek sovereign CDS spreads. Second, during the crisis period, we detected significant causality-in-variance from the Greek sovereign CDS spreads to the bank CDS, implying that the deteriorated Greek sovereign solvency might have triggered contagion effects on the banking sector in the area. Our results are relevant for policymakers who provide regulations for the CDS markets.

Keywords:

• European sovereign debt crisis
• Credit Default Swap (CDS)
• bank sector CDS
• Cross-Correlation Function analysis
• causality-in-variance

JEL Classification:

• C50
• G10
• G15

Notes

¹ We paid attention to this index, which represents a portfolio of single-named CDSs for selected banks in the area, since market participants are more interested in credit risks at the sector level rather than at the individual firm level.

² See Nelson (1991) for details of the EGARCH model.

³ Our choice of the start date is constrained by the availability of the Greek sovereign CDS index data through Datastream, which begins only from 14 December 2007.

⁴ Kasimati (2011) investigated the sovereign debt crisis by analysing through an Error Correction Model (ECM), the causality between the increases in the Greek sovereign bond yield over bund and the devaluation of euro.

⁵ The results of these unit root tests are available upon request.