The Large Movements of Volatility Spreading by the European Monetary union - Free Essay Example

Sample details Pages: 5 Words: 1394 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? Over the last months, European Monetary Union (EMU) countries have experienced large movements in their spreads with an unrecorded degree of volatility. Academic research consensuses agree these movements havent been the result of the same causes over time; for instance, at the beginning of the crisis investors required higher premiums, making the market price of risk increase. There were a preference for few riskier assets, making sovereign securities the favorites at the expense of corporate bonds and other riskier assets; therefore, it creates a new vision and a higher degree of differentiation among financial assets. Don’t waste time! Our writers will create an original "The Large Movements of Volatility Spreading by the European Monetary union" essay for you Create order According to Elizalde Gallo (2008), during the second half of 2007, spreads levels increased because of market turbulence, instead of the risk to default. Credit markets experienced a flight-from-quality phenomenon which increased the perceived credit risk of the safest credit instruments. Moreover, Bernoth, Von Hagen and Schuknecht (2004) conclude that in time of uncertainty, investors move to safer and more liquid assets because of risk aversion. The crisis has increased sovereign risk causing greater budget deficits and stopping the potential growth of the country. At the beginning of the crisis the countries which suffer most because of it were the only one which increased their sovereign credit risk premiums, later on, spreads started to increase in countries highly indebted but with weak fundamentals. Crises increase the pressure on countrys indebtedness and at the same time they make more difficult to sovereign to fulfil debt commitments because of the decreasing path in s overeign economic growth they create. Moreover, because of the existence cross-border spillovers, the transmission of sovereign risk threatens the global financial stability. This paper is based on the methodology developed by Caceres, Guzzo and Segoviano (2010) and it reviews how sovereign swap spreads in the euro area can be discomposed on measures of sovereigns fundamentals (sovereign-specific fiscal situation), global risk aversion and contagion. Additionally, we are going to assess how each of those components have affected the spreads during the current financial crisis, putting special emphasis on the Greek crisis, which has affected many European countries lately. The first component, developed in Espinoza and Segoviano (2010), explores the index of global risk aversion (IGRA) component. IGRA allows us to use CDS spreads in computing probabilities of default by typify the market price of risk relied on risk aversion. The second component is contagion, distress dependence, or Spillover coefficient (SC). SC is developed by Segoviano and Goodhart (2009), and it characterizes the probability of distress of a country conditional on other countries (in the sample) becoming distressed. The third component, country-specific fundamentals (CSF), is obtained by each countrys stock of public debt and budget deficit as a share of GDP. The goal of this paper is may be divided in three parts (i) to probe the approach functionality and accuracy in discomposing spreads regarding each factor (ii) to analyze sovereign risk transmission progress since crisis started, (iii) to broad the spectrum of the original research including recent information. For this goal, we are going to consider our reference period is from July 2007 to date. The structure of the paper is as follows: section III introduces the advantages of the model, section IV develops the theoretical framework around the model, section V describes the estimation model, section VI Describes the Data set t o be use, section VII develops the empirical test, section VIII Describe results, section IX conclusions. The choice of the sovereigns included in the study was based mostly not only on the importance to understand what factors have been most relevant in explaining the distress that Euro Area countries have experienced after the Greek event, but also on data availability. Our study is including ten of the twelve original countries included in the EMU. These countries are Germany, France, Italy, Spain, Netherlands, Belgium, Austria, Greece, Ireland and Portugal. Finland and Luxemburg were excluded because of lack of long and reliable CDS spread information. III. ADVANTAGES OF THE MODEL Although there is previous literature, the approach to be reviewed provides useful insights into the analysis of sovereign spreads by discomposing them onto (i) global risk aversion, (ii) sovereign fundamentals and (iii) contagion. Global risk aversion. There is more research trying to asses the impact of risk aversion; however some of the former papers use proxies affected by other factors resulting in inaccurate conclusions (Codogno et al, 2003). The advantage of all these methods is that they are based in observable measures; therefore information is readily accessible. Other papers, for instance, try to extract the risk-aversion component from sovereign spreads series; therefore, depending on the sample. Segoviano, Caceres, Guzzo (2010) measure of risk aversion is based on the methodology developed by Segoviano, Espinoza (2010) which bigger advantage is that it is independent of the data sample Sovereign fundamentals. We are going to use sovereigns stock of public debt ad budget deficit as a share if GDP. Using linear interpolation on quarterly data, we get daily series. Contagion. Another innovation in the study. The spillover coefficient (SC) is the measure of distress dependence where contagion comes from. SC characterizes the probability of one sovereign getting distressed conditional on other countries getting distressed. SC is a methodology developed by Caceres, Guzzo and Segoviano, (2010) and it is based on Goodhart, Segoviano (2009). Spillover is particularity important under a specific environment such as the EMU. The dependence among sovereigns the spillover coefficient is measuring includes among others trade, capital flows, and contingent liabilities (macro-financial linkages) among them. Contingent liabilities are important, since a sovereign in distress within the EMU becomes a contingent liability to the others. Previous research argues movement in spreads is caused for the level of short-term interest rates due to a strong corr elation not only between interest rates and government bonds spreads, but also between spreads of corporate and government bonds (Manganelli and Wolswijk (2007). They argue that because of low interest rates, investments on the government bond market increased and spreads narrowed; however, during the crisis in 2007, it was not the case. While spreads kept widening, interest rate were historically low; therefore, one of the important questions become, what is driving this spreads-movement if not interest rates?. To include measures or global risk aversion and contagion in the analysis of sovereign swaps spreads makes from this methodology a reliable and innovative alternative. Knowing what are the factors affecting the movements in the spreads and the specific nature of risk transmission into the EMU is a crucial point for decision-making, for instance, sovereign spreads might exhibit movements without any considerable change in their fundamentals. Within the EMU environment, a weak sovereigns fundamentals concern all others, because the sovereign in distress is going to be supported by the rest of the Union. Sovereigns monetary and fiscal policies have a huge impact in government bond yields; therefore bond yields do not allow us to get accurately the default risk premium. Instead, it is proposed to look Credit Default Swap rates (CDS), spread on bonds denominated in the same currency (in this case EURO) or interest rate swap spreads. Any of the proposed options have advantages and disadvantages; however, because of the interest rate swap market is one of the most liquid and because it was one of the first financial markets following the creation of the European Union, Segoviano, Caceres and Guzzo (2010) defined swap spreads as the measure for sovereign default risk for their methodology. To illustrate the importance of the methodology, it is important to describe the findings resulted from its development. For research purposes, Caceres, Guzzo and Sego viano (2010), divided the last global financial crisis in four phases. They defined these phases according to common behavior among sovereigns. The four phases are (i) Financial crisis buildup (July 2007-2008), (ii) Systematic outbreak (October 2008 March 2009), (iii) Systematic response (April 2009 October 2009), (iv) Sovereign risk (November 2009 March 2010). Their finding can be summarizing as follows: Financial crisis buildup (July 2007-2008). Sovereigns such as France and Germany were benefited by increase in risk aversion due to investors behavior to look for safer assets. For other sovereigns, spreads widened Systematic outbreak (October 2008 March 2009). Austria, Belgium, Ireland and Netherlands, sovereigns with financial systems and other concerns, started to struggle. Systematic response (April 2009 October 2009). Risk aversion felt due to policies to support banks. Swap spreads started to narrow. Sovereign risk (November 2009 March 2010). Spillovers and worsening fundamentals among countries with fiscal concerns like Spain, Portugal, Greece and Italy started to have effects and their spreads widened.