Market perception of sovereign credit risk in the euro area during the financial crisis

• We study market perception of sovereign credit risk in the euro area.
• We use a CDS pricing model to estimate the PD and LGD.
• Separate identification of PD and LGD appears empirically tractable.
• The estimated LGDs perceived by financial markets stay usually below 40%.
• Macroeconomic developments were weakly correlated with changes in PD and LGD.

We study market perception of sovereign credit risk in the euro area during the financial crisis. In our analysis we use a parsimonious CDS pricing model to estimate the probability of default (PD) and the loss given default (LGD) as perceived by financial markets. In our empirical results the estimated LGDs perceived by financial markets stay comfortably below 40% in most of the samples. Global financial indicators are positively and strongly correlated with the market perception of sovereign credit risk; whilst macroeconomic and institutional developments were at best only weakly correlated with the market perception of sovereign credit risk.