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Definition and Framework for Contagion and Divergence Effect Modeling

The paper examines contagion effect and divergence effect referring to sovereign bond yields. Both effects should be understood as an increase in interdependency among different class of assets as a result of a signiﬁcant shock. Contagion refers to positive interdependency, while the negative correlation illustrates divergence effect.The contagion/divergence effect is being somehow overlooked by classic risk models, as they base on constant volatility, mean and correlation assumption. The contagion process may be translated into three effects: spillover, transmission and comovement. All these creates a challenge for contagion risk modeling, as different class of models, including both static and dynamic features, must be contemplated. The paper organizes the methodology and presents main concepts for contagion effect modeling within both spatial and time approach. As the same index is utilized for contagion as well as divergence modeling, it is possible to analyses and compare this opposite effects together referring to selected sovereign bond market data.