Financial Econometrics and Empirical Market Microstructure

European Divergence Case Study

The European Divergence Scenario illustrates the Adaptive Stress Testing frame­work well. With the introduction of the Euro, credit spreads converged for all member countries and started an unsustainable cycle of credit growth in high inflation countries like Greece, Italy, Portugal, and Spain. The artificial stability of the Euro currency was a classic Minsky case of stability breeding instability. As hidden imbalances continued to build up in the Euro periphery, Innovators like GaveKal Research analyzed the unsustainability of “PIGS” borrowing levels, and launched a European Divergence Fund in November 2007:

For ten years, investors have made money on convergence trades (i. e., Italian rates falling to meet German rates).These convergence trades were always based on politics, not economics. However, in the long-run, economics always wins out. And now, as credit conditions tighten around the world, should be the time when this happens.—Louis-Vincent Gave, GaveKal Funds Newsletter, November 11th, 2007

Early Adopters: European Divergence (PIGS) investment thesis leads launch of several fund strategies in 2007 (e. g., Gavekal)


Fig. 7 Five year sovereign CDS spreads for PIGS. Source: Laubsch (2010a, b)

Figure 7 shows the escalation of the PIGS sovereign spreads from pre-crisis 2005 when risk was hidden, to 2007 when risk started to emerge and to 2008 when markets went into crisis mode.

As with subprime bonds and equities, outliers were useful early warning signals. Figure 8 shows Greece CDS vs. cumulative VaR outliers. Each wave of escalating spreads is preceded by exceptionally low levels of outliers (e. g., unnaturally low level of variability), and then a rapid phase transition to high volatility marked by escalating outliers.

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