The Role of Redenomination Risk in the Price Evolution of Italian Banks’ CDS Spreads

Abstract

<jats:p>The recent financial crisis offered an interesting opportunity to analyze the markets’ behavior in a high-volatility framework. In this paper, we analyzed the price discovery process of the Italian banks’ Credit Default Swap (CDS) spreads through the Merton model, extended with the inclusion of a redenomination risk proxy, as to say, the risk that Italy could leave the eurozone. This paper contributes to the literature by integrating the classic Merton model with a political-sensitive market variable able to explain the greatest variance in the Italian banks’ CDS spreads during the most relevant and commonly recognized periods of socio-political and financial distress. Results show that the redenomination risk is progressively becoming the main driver of the process during crises, in particular for the sovereign debt crisis and in 2018.</jats:p>

The Dynamic Progression of the Redenomination and Sovereign Risk in the Price Discovery Process of Italian Banks’ CDSs

“…Moreover, it's a country characterized by a high debt-to-GDP ratio, low economic growth and the presence of declared anti-European political parties with growing electoral consensus. Unlike what Kremens (2019) suggests, the idea of this work, in line with the study of Anelli et al (2020), is that a possible exit from the Euro Area of Italy, that is the founding country, the third economy and the second manufacturing of the EU (European Union), could deeply undermine the entire European institutional structure and definitively question the irreversibility of monetary union.…”

“…The risk of a possible breakup of the Eurozone 13 appeared for the first time in 2010, following the events that brought Greece to the brink of bankruptcy 14 . The redenomination risk component, up to that time almost inexistent (see Figure 5), progressively played an important role in the price discovery process of the Italian banks' CDS spreads, thus pricing the risk of a possible Italexit already during the sovereign debt crisis (Anelli et al, 2020). The perception of a hypothetical Italy's currency redenomination is explained by the debt sustainability problems.…”

“…government coalition (anti-establishment or populist) in favor of the growth of the deficit (pro-deficit) and openly against the technocracy of the European Union. This attitude, combined with the will of the coalition parties to leave the Euro Area, declared during and after the electoral campaign, generated the perception that the Brexit experience could also happen in Italy (Anelli et al, 2020). The fundamental difference between the two periods in which redenomination risk component assumed greater statistical significance is given by the various factors that influenced the market behavior.…”

“…The author tries to explain how the negative effects of an Italian exit from the Euro Area can be sufficiently controlled, while a French exit from the monetary union could have a domino effect on the rest of the Eurozone. The main reference paper of the second stream is that of Anelli et al (2020). The authors analyze the price discovery process of the Italian banks' CDS spreads by integrating the variables of the Merton model (1974).…”

“…7 Intesa San Paolo and Unicredit are the largest Italian banks in terms of market capitalization and total assets (Sirletti and Salzano, 2018). In 2018, they accounted for about 45% of the total assets of the Italian banking system (Anelli et al, 2020). Therefore, the idea behind the approximation is expressed by the concept of too-big-to-fail: if one of these groups goes into crisis, it would be logical to think that the entire Italian banking system would be involved.…”