The Possible Breakup of the Euro Zone: Examining the Differences between Credit Default Swap Fees Nominated in Euro and US-Dollar During the Euro-Area Crisis.

Abstract

Before the beginning of the euro-area crisis, fees (premiums) for Credit Default Swaps (CDS) for the same entity (country) but nominated in different currencies were nearly equal. This is still true for non-euro area countries during the crisis; but these differences increased dramatically for euro-area countries since the beginning of the crisis. For some euro-area countries investors have to pay more for Euro compared to US-Dollar nominated CDSs, while for other euro-area countries the opposite is true. This paper analyzes by using a simple theoretical model and thereafter testing empirically the differences between CDS fees nominated in Euro and US-Dollar and concludes that the volatility of the differences is largely explained, next to the US-Dollar-Euro forward rate, by the probability of collapse of the Euro(-currency). Market uncertainty is shown to play a significant role; nevertheless, it only explains a small fraction of the volatility of these differences. Further, our empirical results imply that for the countries analyzed in this paper – Germany, France, Finland and Italy – market participants expect in the case of a euro-collapse and the subsequent failure of the respective sovereign a depreciation of the newly introduced local currency.