The Linkage between Sovereign Defaults and Exchange Rate Shocks in the Eurozone : A Measure for Systemic Risk

We propose a simple method for measuring systemic sovereign credit risk in the Eurozone by linking sovereign defaults to currency shocks. The framework rests on the assumption that systemic sovereign credit risk is high when sovereign defaults induce large shocks to the Euro currency market. We use a dynamic copula model with an asymmetric dynamic conditional correlation (ADCC) specification to reflect dependencies between sovereigns. We study contributions to systemic sovereign credit risk for nine countries in the core and peripheral Eurozone between May 2010 and January 2014. We find that the prevailing level of systemic risk is highly time-varying and peaks around July 2012. The largest systemic risk contribution can be attributed to Portugal. Furthermore, we analyze to which extend various financial market variables explain variation in our indicator. We find that movements in these variables only explain a relatively small proportion of the variation and therefore the indicator must be driven by additional sources of risk