The impact of distressed economies on the EU sovereign market

Financially distressed economies inside the European Union (EU) are being blamed for producing a general increase in borrowing costs. This article analyzes the channels of default risk transmission within the EU countries using the information content in the sovereign Credit Default Swap (CDS) market. We proceed in two directions. First, we test the existence of cross-border volatility effects between the central and the peripheral EU countries. Second, we explore the effect of distressed economies on the 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 the default swap risk premia. On average, the risk premium accounts for approximately 42% of central EMU spreads and 56% of the spreads for those countries outside of the EMU. The peripheral risk also affects the default component of central economies, although its impact is lower.

► We explore the risk transmission between core and peripheral EU economies. ► We decompose the CDS spread into the risk premium and the default components. ► The CDS market enables a risk transmission channel for default risk and risk premium. ► After 2010 the impact of peripheral risk on core countries vanishes over time.