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

Author

Listed:
  • 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)

Abstract

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.

Suggested Citation

  • Debora Revoltella & Fabio Mucci & Dubravko Mihaljek, 2010. "Properly pricing country risk: a model for pricing long-term fundamental risk applied to central and eastern European countries," Financial Theory and Practice, Institute of Public Finance, vol. 34(3), pages 219-245.
  • Handle: RePEc:ipf:finteo:v:34:y:2010:i:3:p:219-245
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    References listed on IDEAS

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    1. Lóránt Varga, 2009. "The information content of Hungarian sovereign CDS spreads," MNB Occasional Papers 2009/78, Magyar Nemzeti Bank (Central Bank of Hungary).
    2. de Haas, Ralph & van Lelyveld, Iman, 2010. "Internal capital markets and lending by multinational bank subsidiaries," Journal of Financial Intermediation, Elsevier, vol. 19(1), pages 1-25, January.
    3. 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).
    4. Stulz, Rene, 2010. "Credit default Swaps and the Credit Crisis," Economic Policy, Russian Presidential Academy of National Economy and Public Administration, vol. 6, pages 157-175.
    5. 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.
    6. 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.
    7. 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.
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    Citations

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    Cited by:

    1. Blumenstock, Hendrik & von Grone, Udo & Mehlhorn, Marc & Merkl, Johannes & Pietz, Marcus, 2012. "Einflussfaktoren von CDS-Spreads als Maß für das aktuelle Bonitätsrisiko: Liefert das Rating eine Erklärung?," Bayreuth Working Papers on Finance, Accounting and Taxation (FAcT-Papers) 2012-03, University of Bayreuth, Chair of Finance and Banking.
    2. Oana Mihaela MARIOARA (ORHEIAN), 2015. "Sovereign Risk And Cds. The Case Of Romania," SEA - Practical Application of Science, Fundația Română pentru Inteligența Afacerii, Editorial Department, issue 7, pages 51-56, April.
    3. Aleksandar Naumoski, 2012. "Estimating the country risk premium in emerging markets: the case of the Republic of Macedonia," Financial Theory and Practice, Institute of Public Finance, vol. 36(4), pages 413-434.

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