A revisit to sovereign risk contagion in eurozone with mutual exciting regime-switching model

This paper proposes a new mutual exciting regime-switching model where crises can spread contagiously across countries. Each country has its own hidden stochastic process that determines whether it is in a normal or crisis regime. The mutual-excitation component allows interactions in the Markov chains, and a crisis in one country could increase the likelihood of a crisis in another country. Using this new approach, I revisit the sovereign risk contagion in the euro area. I find striking shifts in market pricing functions for the sovereign bond spreads. Multi-country contagion plays a dominant role in driving such shifts, while common risk factors and country-specific fundamentals are less important.