Transmission of Financial Stress in Europe: The Pivotal Role of Italy and Spain, but not Greece

This paper proposes a stochastic volatility model to measure sovereign financial distress. It examines howkey European sovereign credit default swap (CDS) spreads affect each other; specifically, the paperanalyses the volatility structure of Germany, Greece, Ireland, Italy, Spain and Portugal. The stability ofGermany is a close proxy for the resilience of the euro area as markets use Germany's sovereign CDS as ahedge for systemic risk. Although most of the CDS changes for Germany during 2009–12 were due toidiosyncratic factors, market developments in Italy and Spain contributed significantly, likely due to theirrelative importance in the region. Changes in Greece's sovereign CDS had no significant effect on Germany's sovereign CDS despite initial widespread concerns about such linkages. Spain and Italy show anotable co-dependence in explaining each other's volatility while Germany also plays an important role. Itis found that extreme bad news led to persistent and nearly permanent effects on the stochastic volatility ofEuropean sovereign CDS spreads.