CEPII, Recherche et Expertise sur l'economie mondiale
Sovereign Risk and Asset Market Dynamics in the Euro Area

Erica Perego

 Highlights :
  • We study the behavior of euro area asset markets from a macroeconomic perspective.
  • We explain the transmission mechanisms that determine the divergence in core and periphery stock-bond returns' comovements during the period 2010-2014.
  • We build a DSGE model for the euro area with a banking sector and international asset markets and we estimate sovereign risk from the data.
  • The model buffeted by this shock is able to reconcile the empirical evidence on economic and finance dynamics during the sovereign debt crisis.

 Abstract :
This paper studies the behavior of euro area asset market co-movements during the period 2010-2014, through the lens of a DSGE model. The economy is a two-country world consisting of a core and a periphery and featuring an international banking sector, international equity markets, home bias in sovereign bond holdings, and sovereign default. The periphery is buffeted by a sovereign risk shock, whose process is estimated from the data. The model accounts successfully for the divergence in core-periphery correlations between stock and sovereign bond returns. The simulation results indicate that the sovereign risk shock explains 50% of the increase in sovereign and loandeposit spreads, and 8% of the decrease in global output during the sovereign debt crisis.

 Keywords : Currency Union | International Financial Markets | Sovereign Risk | General Equilibrium

 JEL : F41, F44, G15
CEPII Working Paper
N°2018-18, November 2018

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