Euro-zone sovereign solvency risk and systemic contagion

Posted on 13. Dec, 2010 by Jean Jacques Ohana in Weekly Focus | Comments Off

From the latest 5 Yrs CDS quotes of various euro zone countries, we can infer the implied cumulative probability of default.

The one year probability of default p may be deduced from the following approximate relationship:

where s represents the CDS price and R represents the recovery (presumably around 35%/40% for OECD countries). This relationship is obtained by equating the NPV of default payment with the NPV of first premium payment considering that the default can only occur at the payment date.

Then, the one year probability of default is approximated by:

Eventually, the implied 5 years cumulative probability of default may be approximated by:



This analysis reveals that despite guarantees from the European Financial Stability Facility and the IMF, financial markets have clearly assessed a solvency issue rather than a mere liquidity problem.


An even more worrying issue is the contagion of the most vulnerable countries solvency issues to the euro zone core countries. The chart of Riskelia’s risk aversion indicator shows that all solvency stresses are highly correlated:



The normalized risk aversion may be used to monitor the relative evolution of vulnerabilities compared to their own recent history and the picture is very different from the absolute one:


Therefore, the core euro zone countries are the ones whose risk has increased the most in relative terms. The message of financial markets is very clear: the euro zone debt situation as a whole is not sustainable.

And when the euro solvency risk becomes more acute (which is bound to happen at some point), it will spread to the whole system as the euro specific solvency risk is correlated at 0.6 to the Global Risk Aversion.


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