Disentangling contagion among sovereign CDS spreads during the European debt crisis

•We fit the sovereign CDS spreads of ten OECD countries with a dynamic factor model.•We get three components; one of them is driven by European peripheral countries.•We identify contagion among countries with the real-time estimates of the model.•The procedure is dynamic and does not impose a unique country as contagion trigger.

During the last crisis, developed economies' sovereign credit default swap (hereafter CDS) premia have gained in importance as a tool for approximating credit risk. In this paper, we fit a dynamic factor model to decompose the sovereign CDS spreads of ten OECD economies into three components: a common factor, a second factor driven by European peripheral countries and an idiosyncratic component. We use this decomposition to propose a novel methodology based on the real-time estimates of the model to characterize contagion among the ten series. Our procedure allows the country that triggers contagion in each period, which can be any peripheral economy, to be disentangled. According to our findings, since the onset of the sovereign debt crisis, contagion has played a non-negligible role in the European peripheral countries, which confirms the existence of significant financial linkages between these economies.