How quantitative easing changes the nature of sovereign risk

Abstract

We model the market stabilization function of quantitative easing (QE) programs as a put option written by the central bank to bond holders. This implicit put option protects bond holders against tail risks, in particular sovereign credit risk. The contingent claims model (CCM) that we use to value the implicit put option has not been applied to QE in the literature before. Based on this model, we examine the effect of the European Central Bank’s bond purchases by QE on the sovereign credit risk of eight countries of the Economic and Monetary Union (EMU). Model simulations show that in times of market stress investors attached a high value to the implicit put option on sovereign bonds. This indicates that QE lowers investors’ perception of sovereign default risk. Understanding this effect of QE is important for addressing tail risks in the euro area via a backstop facility.