European Sovereign Debt Crisis

European Sovereign Debt Crisis Free Essay

Abstract

The European Sovereign Debt Crisis has emerged as one of the greatest challenging aspects regarding financial issues for the policy makers and the governments. Clearly, the issues of financial contagion and the empirical financial market have been significantly affected by the European Sovereign Debt Crisis (ESDC) for a long time, through the market participants and the cross-market interdependencies. Furthermore, the adverse impacts of the sovereign debt crisis spreading to other sections of the financial institutions affect the asset prices and other related dynamics. The strength and the scope of economic instability trigger the consequences of spillovers and the appearance of danger of contagion. In particular, the origin of the European sovereign debt crisis has been attributed to the incomprehension of the fragility of the financial institution and the flawed design of the euro. On the other hand, the contagion in regard to commercial networks results in a default generation of spillovers and other sovereigns debts.

 

European Sovereign Debt Crisis

Introduction

The fundamental structure of any financial system requires that the financial market initiate the flow of money to facilitate the investments made by individuals, governments, and corporations. Simultaneously, the financial institutions serve as the intermediary for the movement of funds. Therefore, for the euro debt crisis to affect the financial market, it must interfere with the key components that facilitate the flow of funds in it. As an illustration, when the debt crisis affects the financial institutions, it is likely that the financial market will be impacted by the crisis significantly. The market value fell and became volatile, which resulted in the elevation of the cost of funds provided for the financial institution. The European sovereign debt crisis increased market volatility while also increasing price movements through the consequent contagion effects.

Volatility

The European sovereign debt crisis influenced the world's market volatility by affecting the financial markets and the foreign exchange markets. Consequently, the immediate and long-term effects led to the development of new policies aimed to counter any future risks.

The Impact of European Sovereign Debt Crisis on the Financial Market

The sovereign debt crisis has a significant impact on the financial institutions, forex markets, and the sovereign bonds together with the stock and market derivatives (Alsakka and Gwilym 2014). By extension, the European sovereign debt crisis exerts a considerable amount of pressure on the financial market through a variety of avenues. For instance, the increase in the fee for funding endangers the assets in the financial institution and therefore, the impact is felt by the financial market. Furthermore, the financial markets in the nations affected by the problem of sovereign debt suffer from asset substitution and capital outflows.

Alsakka and Gwilym (2013) state that the European sovereign debt crisis negatively affects both the global financial market and the concerned countries that have already been severely affected by sovereign debt crisis. As an illustration of the adverse implications of the crisis, investors react to the bad news of financial turmoil by swiftly selling the dangerous assets and buying the government bonds with the most financially stable countries. As a result, the bond markets of the distressed countries perform poorly because of the falling prices.

The sovereign debt crisis influences the global trade by affecting various factors of production, including efficiency, consumer demand, supply, and investor demand. Because of the debt crisis, the average financial growth rate has fallen significantly. Therefore, financial market efficiency determines the improvement policies for the markets that have suffered the critical debt crisis. The impact of the euro debt crisis can be quantified in regard to its effects on the financial market (Beirne, & Fratzscher 2013). Similarly, the understanding of the external spillover emerging from the debt crisis is necessary in order to determine the extent of the impact on the financial market.

The sovereign debt crisis increases the government bonds and the spread of fluctuations between the bond yields and the risk aversion. Nonetheless, the growth in the bond yields associated with the sovereign debt crisis is based on a massive increase in the spread of government bond. Also, another strong effect of the debt problem is the depreciation of euro currency and the appearance of mistrust toward the financial market systems.

Impact on the Global Economy and Foreign Exchange Market

The financial problems caused by the European countries restricting their liabilities because of high-risk borrowing practices have partially contributed to the development of the crisis and its aftermath in the period of 2010-2015. The financial market plays an important part for financial and business partners in the financial markets. Consequently, because of the panic experienced around the different kinds of markets, the volatility of the economic situation develops. Moreover, the financial institutions face a combination of uncertainties that require a quick financial bailout.

The effect of sovereign debts crisis is evident in the Eurozone, because the US dollar is normally preferred to the Euro. By extension, the global value of the euro is more prone to changes in the vulnerable member countries of the Eurozone. Benito, Guillamón, & Bastida (2016) suggest that the empirical strength of the currency is directly and positively related to the economic and financial market stability, which allows investors to release securities and transfer them to other countries. All in all, the financial market investors’ confidence has been abating, hence applying a downward pressure on the market currency.

Contagion from the European Sovereign Debt Crisis

Financial contagion occurs when the volatility of the income of certain assets increases drastically, presenting a higher correlation between the property (Allegret, Raymond, & Rharrabti 2015). Likewise, contagion can exist when the asset class is exposed to the same risk or a related set of risks. Therefore, the contagion effects of the crisis cause the financial instability that increases the dimensions of the economic imbalances, making them unsuitable for a proper crisis management. The phenomena of contagion have a crucial role in the exacerbation of the sovereign debt issues. Besides, the financial frameworks of contagion in the sovereign debt crisis have become important from the economic point of view. Blundell et al. (2011) argue that credit markets perceive the potential spillovers in the sovereign debt to be of a small magnitude. Also, the losses incurred due to contagion suggest that the sovereign debt is interconnected economically with the cost of borrowing. In short, the risk of contagion caused by direct losses in comparison to debt holdings is relatively small. The estimation brings into contention a significant channel of contagion that enhances the benefits and the cost of the bailout.

From the perspective of policy and economic meaning, the financial markets navigate through a contractual resolution to the essence of the problem of the sovereign debt crisis. Consequently, the financial stability presented by managing contagion risks provides a primary objective for coordinating the activities of the policy makers and the market participants. Most importantly, the surveillance of systematic risk and the provision of quick liquidity, as efficient as required, make the sovereign contagion policy an appropriate tool in regard to the economic reforms. Therefore, determining and understanding the magnitude of credit risk and financial contagion is essential to policy making.

Market Volatility and Dynamic Correlation in Regard To Stock Market during the European Sovereign Debt Crisis

Price volatility is a key feature in the financial market commodity, because the commodities have the capability of achieving a greater volatility fee than the services (Drenovak 2014). Consequently, from the perspective of the European sovereign debt crisis, the real volatility worth is determined by the fact that the commodity can change with time. Still, the demand and supply for the financial markets can cause short-term elasticity in order to influence prices and the production of products. In fact, the increasing significance of financial market investment in the commodity trade reflects on the supply and demand factors. The sovereign debt crisis heightens the risk of speculation, which consequently makes the prices prone to rising.

Featherstone (2011) argues that an impact on volatility mostly depends on news, though financial asset pricing keeps shifting. Since volatility depreciates with an increase in volume, the changes expected in regard to the transaction volume rise. However, the sovereign debt crisis has resulted in slow economic growth and played a role in the emergence of reduced performance of the stock market. Specifically, the dynamic correlation and volatility transmission influence the emerging stock market. Similarly, the equity market has experienced a major decline during the debt crisis, with the spread of the market capital affecting the emerging market spillovers. The dynamic correlation during the period of debt crisis mainly relates to the growth of interdependent stock market. Substantially, the most volatile mature market in regard to the capital lacks the domestic investors and the local institutions to invest in the equity markets. The sovereign debt crisis causes an overreliance on foreign investors who reduce the diversifying of the benefits of portfolios. By extension, the financial market volatility increased in the European nations during the debt crisis, having asymmetrical effects on bond return volatilities. Various upgrades lack a meaningful outcome for the volatility bonds.

Correlation between Different Asset Classes

Organized asset allocation requires that the various asset classes correlate with one another. For instance, when comparing two commodities, X and Y, the regarding of the investment is a starting point for accessing a remarkable diversity of the portfolios. In short, the correlation between the different asset classes offers an allocation of resources that is well distributed for investment purposes. Furthermore, the correlation between the portfolio benefits depends on the investors in various asset categories, like real estate, stocks, and bonds. In the times of sovereign debt crisis, a decent correlation and classification of asset classes provide an insight into the best investment moves an individual can venture into, considering the international financial market environment that keeps changing during the debt crisis.

The time-varying correlation between the classifications of cross-asset diversification has some benefits in regard to bond markets. The principle of correlation in the financial market is solely concerned with the risk-return association, as long as the investor can determine that the overall portfolio risk is low. However, during the times of sovereign debt crisis, a rational investor should establish the assets correlation between the management investments over a certain period of time, in order to get an actual indicator of the real benefits.

The Impact of European Sovereign Debt Crisis on Bond Markets

The bond market reacts negatively toward bad news caused by the sovereign debt crisis, and the government bonds that are still in the process of developing maturity suffer significantly. Still, the national bond indices create adverse effects on the market spillovers. Consequently, when the bond market is subjected to pressure from sovereign debt issues, the bond pricing becomes abnormal, and its spreads also increase. In short, the bond spreads triggered by the asymmetrical information and poor government policies produce unstable bond markets (Aizenman, Hutchison, & Lothian 2013). As a matter of fact, the European bond markets integrate the linkages between the policy makers and the market participants, which helps to formulate appropriate strategies for risk management and make investment decisions in order to stabilize the bond market. Similarly, the bond market employs empirical stabilization mechanisms that are aimed to positively impact the bond markets.

Investors consider sovereign bonds as risk-free assets by assuming that the government can never fail. Besides, in case the government experiences financial difficulties, the investors expect them to raise the taxes or look for other ways of receiving payments to compensate for their debts. However, when the debt crisis erupted, the indicators of fiscal space sharply rose, so now the bond rates can offer financial harmony. The euro sovereign debt crisis resulted in the effects of cross-relation and volatility spillover for the bond markets. According to Kazi et al. (2014), the economic health of a nation affected by sovereign debt issues is estimated in regard to the bond indices. On the other hand, the investors are worried about the negative unfulfilling sentiments of the market, and thus react by increasing the spreads. Most importantly, foreign and domestic interests spread in the bond market because of the spillovers of unexpected news that build an upward pressure.

The Impact of European Sovereign Debt Crisis on the CDS Market

The Credit Default Swaps (CDS) has seen its activities increase since the beginning of the financial debt crisis. Besides, the CDS has a duty of implementing the proposals presented by the Dodd-Frank. The CDS market has remained active since the onset of the debt crisis in order to ensure that the financial market is transparent, simultaneously minimizing the counterparty risk of credit. Consequently, the CDS increased rapidly as soon as the global monetary fund identified the prominence of sovereign risks. The European sovereign debt crisis has the potential to influence the growing market of CDS to a great extent. In addition, the sovereign debit market determines a pattern of transmitting information between the bond markets and the corresponding CDS market. According to Beirne & Fratzscher (2013), the market discomfort caused by the sovereign debt crisis changes the mutual influence that the bond market and CDS market share. By extension, the CDS market thrives well even with a distressed market setup. The agreement for the CDS market to execute the terms of the contracts of a sovereign creditor would result in the restructuring payment systems to accommodate the estimations of bonds and debts, aimed to warrant the financial stability.

Conclusion

During the period of sovereign default, the international financial market comprises numerous aspects of financial systems that coordinate in order to transmit funds to the intended end-users by using the available intermediaries. Besides, a proper financial system provides services that allow individuals to connect with the existing wealth portfolios. Nevertheless, the financial market environment quickly changes when the sovereign debt crisis comes into play. The European Sovereign Debt Crisis has resulted in severe conflict between the countries in regard to the financial markets. Ultimately, the debt crisis has threatened the recovery of the global economy, because the Eurozone is an important capital market partner for the rest of the world. Specifically, the financial market environment affects the various aspects of the financial system, such as the equity markets, bond markets, and foreign exchange markets.


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