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Properly pricing country risk: a model for pricing long-term fundamental risk applied to central and eastern European countries

  • Debora Revoltella

    (UniCredit Group – Bank Austria, CEE Strategic Analysis, Wien)

  • Fabio Mucci

    (UniCredit Group – Bank Austria, CEE Strategic Analysis, Wien)

  • Dubravko Mihaljek

    (Bank for International Settlements, Basel)

The private sector has used proxies such as sovereign credit ratings, spreads on sovereign bonds and spreads on sovereign credit default swaps (CDS) to gauge country risk, even though these measures are pricing the risk of default of government bonds, which is different from the risks facing private participants in cross-border financing. Under normal market conditions, the CDS spreads are a very useful source of information on country risk. However, the recent crisis has shown that the CDS spreads might lead to some underpricing or overpricing of fundamentals in the case of excessively low or excessively high risk aversion. In this paper we develop an alternative measure of country risk that extracts the volatile, short-term market sentiment component from the sover eign CDS spread in order to improve its reliability in periods of market distress. We show that adverse market sentiment was a key driver of the sharp increase in sovereign CDS spreads of central and eastern European (CEE) countries during the most severe phase of the crisis. We also show that our measure of country risk sheds some light on the observed stability of cross-border bank flows to CEE banks during the crisis.

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Article provided by Institute of Public Finance in its journal Financial Theory and Practice.

Volume (Year): 34 (2010)
Issue (Month): 3 ()
Pages: 219-245

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Handle: RePEc:ipf:finteo:v:34:y:2010:i:3:p:219-245
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  1. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
  2. Ralph De Haas & Iman Van Lelyveld, 2008. "Internal capital markets and lending by multinational bank subsidiaries," Working Papers 105, European Bank for Reconstruction and Development, Office of the Chief Economist.
  3. Rene M. Stulz, 2010. "Credit Default Swaps and the Credit Crisis," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 73-92, Winter.
  4. Lóránt Varga, 2009. "The information content of Hungarian sovereign CDS spreads," MNB Occasional Papers 2009/78, Magyar Nemzeti Bank (the central bank of Hungary).
  5. Haibin Zhu, 2004. "An empirical comparison of credit spreads between the bond market and the credit default swap market," BIS Working Papers 160, Bank for International Settlements.
  6. Norden, Lars & Weber, Martin, 2004. "The comovement of credit default swap, bond and stock markets: An empirical analysis," CFS Working Paper Series 2004/20, Center for Financial Studies (CFS).
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