Tue Feb 17, 2015 5:35am EST
(Refiles to clarify size of stock market drop in headline) (Updates with Greek markets opening)
By Marius Zaharia
LONDON Feb 17 (Reuters) - Greek bond yields jumped by up to 130 basis points and stocks fell 1.5 percent on Tuesday after Athens rejected a proposal to extend its international bailout by six months, raising doubts about its future in the currency union.
The moves reflected heightened investor concern, but neither bonds nor stocks hit the extreme levels seen last week, with the underlying expectation in the market still being that a deal would eventually be reached.
The spillover into other markets was limited. Italian and Spanish borrowing costs rose 2-3 basis points on the day but remained within half a percentage point of their record lows.
"The risk of a collapse is more elevated now because time is running out," said Patrick Jacq, rate strategist at BNP Paribas.
"This is putting Greek government bonds under pressure but contagion effects will remain relatively limited ... Eventually a deal is likely to be reached."
Talks on Monday between Greece and other euro zone finance ministers broke down in less than four hours, far sooner than expected. On Tuesday, both parties said they were open to a resumption of talks.
Jeroen Dijsselbloem, who heads the euro zone's finance ministers' group, said Greece had until Friday to request an extension of its bailout. He said he was ready to work with the Greek government towards a deal.
Greek Finance Minister Yanis Varoufakis voiced confidence that a deal on different terms could be reached within days.
"The length of the meeting seemed alarmingly short," said Orlando Green, rate strategist at Credit Agricole.
"(But) comments following the meeting offered a glimmer of hope for a timely deal."
Greek 10-year bond yields rose 70 basis points to 10.62 percent, while three-year bond yields were up 130 bps at 19 percent.
Ten-year yields approached 12 percent last week and three-year yields topped 22 percent - levels not seen since Greece's default in 2012.
For a factbox of holders of new Greek debt see .
Athens' main ATG share index fell about 1.5 percent to 847.02 points - well above a trough of 708.61 touched after the leftist Syriza party won last month's Greek election. An index of Greek banking stocks dropped 1 percent.
Still, the cost of insuring Greek debt against default, as reflected by five-year credit default swaps, rose to 1,813 basis points from 1,526 bps, according to data from Markit. That implied investors saw a default probability of about 80 percent.
The European Central Bank will decide on Wednesday whether to maintain emergency lending to Greek banks that are bleeding deposits at an estimated 2 billion euros a week. If that pace were maintained, the lenders would run out of collateral for funds within 14 weeks, according to JPMorgan.
"A failure to reach an agreement in the coming weeks could easily trigger bank runs, ECB liquidity withdrawal, and even a Grexit," said Jan von Gerich, chief fixed income analyst at Nordea. "The stakes are thus high."
Yields on top-rated German Bunds fell 1 basis point to 0.34 percent, within touching distance of their 0.299 percent record low.
Spanish and Italian 10-year bond yields were up 2-3 basis points at 1.61 percent and 1.65 percent, respectively. They were up by roughly 10 bps earlier in the day, but next month's launch of an ECB programme to buy around 1 trillion euros of government bonds has effectively capped borrowing costs across the euro zone, apart from Greece. (Editing by Susan Fenton)
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