Measuring Contagion-Induced Funding Liquidity Risk in Sovereign Debt Markets

Cho-Hoi Hui, Chi-Fai Lo, Xiao-Fen Zheng and Tom Fong ()
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Cho-Hoi Hui: Hong Kong Monetary Authority
Chi-Fai Lo: The Chinese University of Hong Kong
Xiao-Fen Zheng: The Chinese University of Hong Kong

No 182015, Working Papers from Hong Kong Institute for Monetary Research

Abstract: The euro-area sovereign debt crisis demonstrated how liquidity shocks can build up in a sovereign debt market due to contagion. This paper proposes a model based on the probability density associated with the dynamics of sovereign bond spreads to measure contagion-induced systemic funding liquidity risk in the market. The two risk measures with closed-form formulas derived from the model, are (1) the rate of change of the probability of triggering a liquidity shock determined by the joint sovereign bond spread dynamics of the systemically important countries (i.e., Italy and Spain) and small country (i.e., Portugal); and (2) the distress correlation between bond spreads, which can provide forward-looking signals of such risk. A signal of the rate of change of the joint probability appeared in April 2011 before the liquidity shock occurred in November 2011. There exist endogenous critical levels of sovereign spreads, above which the signal materializes. The empirical results show that when funding cost, risk aversion and equity prices pass through certain levels, the rate of change of the joint probability will rise sharply.

Keywords: European Sovereign Debt Crisis; Liquidity Risk; Contagion (search for similar items in EconPapers)
JEL-codes: F30 G13 (search for similar items in EconPapers)
Pages: 42 pages
Date: 2015-08
New Economics Papers: this item is included in nep-ban, nep-fmk and nep-opm
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