Sovereign risk and asset market dynamics in the euro area

This paper studies the behavior of euro area asset market co-movements during the period 2010-2014, through the lens of a DSGE model. The economy is a two-country world consisting of a core and a periphery and featuring an international banking sector, international equity markets, home bias in sovereign bond holdings, and sovereign default. The periphery is buffeted by a sovereign risk shock, whose process is estimated from the data. The model accounts successfully for the divergence in core-periphery correlations between stock and sovereign bond returns. The simulation results indicate that the sovereign risk shock explains 50% of the increase in the sovereign spread and of the decrease in global investments, and 7% of the decrease in global output during the sovereign debt crisis. (C) 2020 Elsevier Ltd. All rights reserved.