Determinants Of Sovereign Risk Research Articles

Investigating the behaviour of sovereign risk for Eurozone countries

ABSTRACT The article examines the determinants of sovereign risk for European Monetary Union countries taking into consideration the global financial crisis, which emerged as a sovereign debt crisis in Europe. Using CDS prices, as a proxy of sovereign risk, this study finds that bond yields, equity prices and exchange rate are the key drivers of CDS prices. Moreover, our findings support models with dynamic components and regional effects between core and peripheral Eurozone countries, providing evidence of major differences in risk evaluation.

Banks’ international assets and sovereign default risk

PurposeThis paper aims to investigate the nexus between banks’ foreign assets and sovereign default risk in a panel of 15 developed economies. The empirical evidence suggests that banks’ foreign exposure is an important determinant of sovereign default probability.Design/methodology/approachUsing data from the consolidated banking statistics (total foreign claims on ultimate risk basis) by the Bank of International Settlements, the author constructs a measure of bank international exposure to peer countries. This measure is then used as the target variable in a panel regression for sovereign credit default swaps. The model includes 15 European and non-European developed economies. Identification is discussed extensively in the paper.FindingsQuantitatively, a 1% increase in banks’ cross-border claims increases sovereign default risk by about 0.19%. The relationship is weaker when banks are more capitalised. On the other hand, governments are more vulnerable to credit risk spillovers from banks’ international portfolios when having higher debt to GDP ratios.Originality/valueTo the best of the author’s knowledge, this is the first paper that attempts explicitly to establish an empirical connection between banks’ international assets and sovereign default risk. To the author’s opinion, this paper represents a contribution to our understanding of how sovereign credit risk spills over across countries. It also extends significantly the existing literature on the determinants of sovereign risk (that primarily focused on fundamentals, market characteristics – such as liquidity – and global factors). This paper ultimately sheds some new light on the role of intermediaries in the international transmission of credit risk, also adding to today’s discussion about the linkages between banks and sovereigns.

Panel multi-predictor test procedures with an application to emerging market sovereign risk

As a response to the inefficient practices and possibly misleading inferences resulting from the unit-by-unit application mostly found in the literature, the current paper develops a block bootstrap based panel predictability test procedure that accommodates multiple predictors. As an empirical illustration we consider emerging market sovereign risk where data are usually available across multiple countries, and local and global predictors. The results, which are in agreement with the existing literature on the determinants of sovereign risk, suggest that the global predictors are best and that the predictive ability of the local predictors is limited, at best.

Exchange Rates, Carry Trade Returns and Political Risks

This paper elucidates the channels through which sovereign risk, exchange rates and currency risk premia are related. I show that the channels are different depending on whether a country is classified as emerging or an advanced economy. Generally, for emerging market economies, local sovereign risk factors, namely country-specific political risk and macroeconomic risk do play a significant role in the depreciation of the local currency relative to the U.S. dollar. Whilst there is no convincing evidence that local determinants of sovereign risk cause a depreciation of currencies of advanced economies before the 2007 financial crisis, I do find that political risk does matter for advanced economies in the post-crisis era. For both sets of economies, global factors also play an important role in the relationship between sovereign risk and exchange rates. Secondly, double-sorting 34 currencies into different portfolios based on the level of macro risk and political risk, I provide evidence that local determinants of sovereign risk are priced in the FX markets, i.e. they can forecast currency carry trade excess returns in the cross-section. Local political risk in particular seems to have become an important carry trade risk factor in the post-2007 financial crisis era. This is the first research to explain carry trade excess returns with local sovereign risk factors as against sovereign risk as a whole.

Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt*

This paper investigates the effects of macroeconomic fundamentals on emerging market sovereign credit spreads. We find that the volatility of terms of trade in particular has a statistically and economically significant effect on spreads. This is robust to instrumenting terms of trade with a country-specific commodity price index. Our measures of country fundamentals have substantial explanatory power, even controlling for global factors and credit ratings. We also estimate default probabilities in a hazard model and find that model implied spreads capture a significant part of the variation in observed spreads out-of-sample. The fit is better for lower credit quality borrowers.

A Ratings Based Approach to Measuring Sovereign Risk

We propose a new approach to measuring sovereign default risk. We use sovereign credit ratings and historical default rates provided by credit rating agencies to construct a measure of ratings implied expected loss. We compare our measure of expected loss from sovereign defaults with stand-alone credit ratings and also examine its relationship with credit default swap spreads. We show that our measure is more informative for measuring sovereign risk. We re-examine the fundamental determinants of sovereign risk and find further evidence to support the debt intolerance and original sin explanations for country risk. This study contributes an improved understanding of the value of sovereign credit rating teams in assessing the long-term country risks accompanying emerging market investments.

Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt

This paper investigates the effects of macroeconomic fundamentals on emerging market sovereign credit spreads. We find that the volatility of terms of trade in particular has a statistically and economically significant effect on spreads. This is robust to instrumenting terms of trade with a country-specific commodity price index. Our measures of country fundamentals have substantial explanatory power, even controlling for global factors and credit ratings. We also estimate default probabilities in a hazard model and find that model implied spreads capture a significant part of the variation in observed spreads out-of-sample. The fit is better for lower credit quality borrowers.