Network Risk in the European Sovereign CDS Market

Zornitsa Todorova



This paper applies novel tools from spatial econometrics to measure, quantify and predict sovereign CDS spreads. Network risk is modelled by making each sovereign's CDS spread a function of the CDS spreads of its “neighbors” in the financial network. The main findings of the paper are: (1) the network model improves forecasting accuracy by 15 % to 20%; (2) exogenous financial shocks propagate in the network of sovereigns and 40 % to 50% of the total effect is due to indirect (network) effects. These findings suggest an alternative explanation to the well-known credit spread puzzle. To rationalize the findings the paper develops a simple structural network model of sovereign credit risk with financial cross-holdings and multiple equilibria


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