European Sovereign CDS Premia during the Crisis – A Cointegration Analysis

In this paper, I use multivariate time series models in order to analyze the evolution of European Sovereign CDS spreads during the recent crisis. I find evidence that sovereigns’ credit risk premia are non-stationary but cointegrated with simple measures of the countries’ indebtedness and the overall default risk in the economy. Vector error correction models are estimated on the individual country and aggregated European level, using monthly averages of sovereign and iTraxx CDS as well as debt-over-GDP ratios. Rising public debt levels are found to explain about half of the structural CDS level increases since the outbreak of the financial crisis. Yet, the largest part of sovereign CDS variance cannot be attributed to macroeconomic fundamentals and originates from the interaction with the overall CDS markets. A structural break analysis suggests two different regimes with a significant repricing of sovereign risk. With the onset of the European debt crisis there is evidence for an increased interaction with the financial sector as measured by the iTraxx Fin.