Contagion in Europe

The financial and economic crisis that started in August 2007 is turned into a sovereign debt crisis in spring 2010. Widespread instabilities repeatedly reached new heights since the summer of 2011. From the perspective of ECB, the phenomenon which is at the very center of what we are experiencing in the euro area is contagion. The aim of this document is to study the contagion effect in Europe, and is organized as follows. Firstly, the author has carried out a literature review on the concept of contagion, introducing the definition and the main research results in this field. Then, the focus is on analyzing whether there is contagion effect in Europe, particularly contagion between the yield spreads in Eurozone, based on one model proposed by Carlo Favero and Alessandro Missale (2012). The finding is that default risk is the main driver of the yield spreads in the Eurozone, and more importantly, there exists a clear sign of contagion in the pricing of default risk. Finally, in the light of the empirical results of the previous section, a Eurobond backed by joint guarantees as a solution to the euro debt crisis is introduced.