Systemic Sovereign Risk and Asset Prices: Evidence from the CDS Market, Stressed European Economies and Nonlinear Causality Tests

This empirical study attempts to measure the direction of effects related to systemic sovereign risk (i.e. proxied by CDS prices) on a number of asset prices in four heavily stressed European economies: Greece, Ireland, Italy and Spain. The paper is innovative in terms of addressing the drawbacks of linear causality by making use of both the Sato et al. (2007) methodological approach, which introduces time-varying vector autoregressive modeling, as well as the Hatemi-J (2012) asymmetric causality test that explicitly introduces asymmetries in causality. The empirical findings suggest that the presence of CDS derivatives aggravated the prices in a number of assets. These results are associated with the overall negative environment in economies that experienced the sovereign debt crisis and had to go through a dramatic reduction in market liquidity as well as strict consolidation programs that led these markets to crash. The findings have important implications for the ongoing debate about how to reform the financial system so as to mitigate systemic risk in the future.