15 October 2018

ECB: Working paper: Beyond spreads: measuring sovereign market stress in the euro area

Quantifying stress in sovereign bond markets is a relevant task since such tensions can easily spill over to other important financial market segments, raising the odds of a systemic crisis in the financial system as a whole. The so-called sovereign-bank nexus is a case in point for one possible transmission mechanism via which sovereign market stress may become systemic. In the literature sovereign stress is usually measured in terms of either the yield spread of a particular government bond against a “safe” benchmark bond, or by the spread of a credit default swap written on government debt. Both indicators are usually interpreted as a measure of the (excess) default risk premium embedded in the price of a more risky government bond.

In this paper authors develop a composite indicator of sovereign market stress which is based on a wider set of stress symptoms that includes, apart from yield spreads, a measure of yield volatility and bid-ask spreads. We also use country information from both the short and the long end of the yield curve. All these different measures of sovereign stress are aggregated into a composite indicator based on the methodology of the ECB’s Composite Indicator of Systemic Stress, CISS. In order to recognise this affinity, they call their indicator the Composite Indicator of Systemic Sovereign Stress, or just SovCISS. Accordingly, the SovCISS results as a correlation-weighted average of its components which are homogenised in a particular way before the aggregation step. The basic idea is that the overall level of sovereign stress increases (decreases) with a stronger (weaker) correlation between the different measures of stress symptoms. Authors compute the SovCISS both for euro area member states individually and for the euro area as a whole. The latter provides a yardstick for quickly gauging the extent to which sovereign stress is a more local or a more widespread phenomenon within the euro area.

In an empirical application of our SovCISS indicators, they follow the spillover model as developed by Diebold and Yilmaz (2009 and 2012). They use their model to estimate directional spillover patterns across eleven sovereign bond markets of the euro area between September 2000 and April 2018. Evidence points to little actual contagion from smaller (and less liquid) countries to the remaining (and more liquid) euro area economies during the most acute phases of the sovereign debt crisis.

Full working paper

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