Network Risk in the European Sovereign CDS Market

This paper applies novel tools from spatial econometrics to measure, quantifyand predict sovereign CDS spreads. Network risk is modelled by making each sovereignísCDS spread a function of the CDS spreads of its ìneighborsî in the Önancial network. Themain Öndings of the paper are: (1) the network model improves forecasting accuracy by 15% to 20%; (2) exogenous Önancial shocks propagate in the network of sovereigns and 40 %to 50% of the total e§ect is due to indirect (network) e§ects. These Öndings suggest analternative explanation to the well-known credit spread puzzle. To rationalize the Öndingsthe paper develops a simple structural network model of sovereign credit risk with Önancialcross-holdings and multiple equilibria.