Regime-dependent determinants of Euro area sovereign CDS spreads

We study the determinants of sovereign CDS spreads of five Euro area countries (Greece, Ireland, Italy, Portugal, and Spain) after the collapse of Lehman Brothers. We find that global and/or European Monetary Union (EMU)-wide factors are the main drivers of changes in the sovereign CDS spreads in our sample. However, the impacts of those factors change with market uncertainty. There is a relatively tranquil regime where market uncertainty is low and a relatively turbulent regime where market uncertainty is high. The transition from the tranquil regime to the turbulent regime is driven by changes in the global jump risk, which suggests that contagion from the global financial market significantly affected the pricing of sovereign credit risk in our sample. Domestic economic and financial indicators have little impact on the pricing of sovereign credit risk in all sample countries except Italy. But changes in the sovereign credit risk have significant impacts on domestic economic and financial indicators. Neglecting the financial contagion and feedback effects from sovereign credit risk to domestic economic and financial developments leads to spurious results regarding the determinants of sovereign CDS spreads.