Political Uncertainty, Credit Risk Premium and Default Risk

Abstract

I empirically decompose sovereign credit spreads into a default-risk component and its associated (credit) risk premium and study the effect of political uncertainty on them. On average, credit risk premia account for 42 percent of the observed spreads in the European sovereign credit market. I find that a 10 percent increase in political uncertainty leads to a 3 percent increase in both components after a month. A regional-level analysis reveals heterogeneity in the response of sovereign risk to variations in political uncertainty. This work enriches the understanding of how macroeconomic forces drive variations in sovereign risk and introduces political uncertainty as a significant factor driving the European credit market.