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The Debate over Sovereign Risk, Safe Assets, and the Risk-Free Rate: What are the Implications for Sovereign Issuers?

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  • Hans J. Blommestein

    (Bond Market and Public Debt Management Unit, OECD)

Abstract

This paper seeks to dispel or at least reduce the confusion surrounding the related key concepts of the risk-free rate, safe assets, and sovereign risk, which are central to policy and academic discussions. This confusion gives rise to a lack of consensus as to how to define, measure, and price “sovereign risk,” thus creating a major obstacle to assessing sovereign borrowers’ stress. In this paper, safe assets are considered to be those that are virtually default- free. These so-called safe assets function as “information-insensitive” instruments (they serve as “money” and have the associated basic functions of money, such as collateral and backing of checkable deposits of commercial banks and money-market funds). The return on these assets is the (relatively) risk-free rate. The pricing of risky assets involves assessing or evaluating the risk dimensions of relative asset safety. A significant complication in carrying this out is the fact that the market is often driven by emotions, or animal spirits. Sometimes these market emotions change rapidly, having a knock-on effect on the (mis)pricing of relatively safe assets and sovereign risk. The track record of sovereign-risk pricing is not very impressive, characterized by prolonged periods of risk under-pricing (excessively compressed spreads) followed by risk overpricing (sudden widening of spreads). Market measurements (including ratings) thus seem somewhat unreliable. One should, therefore, be extremely cautious in concluding that the sovereign debt of an OECD country has indeed lost its “risk-free” status. At the same time, the overarching strategic objective of debt managers is to raise funds at the lowest possible cost within the boundaries of a preferred risk level. This implies for the sovereign borrower a two-part goal: issuing (relatively) risk-free sovereign debt and preserving this relatively risk-free status. Reinforcing government borrowers’ focus on this strategic objective is the knowledge that a steady supply of safe sovereign assets is essential for the smooth functioning of the worldwide financial system (for allocating resources, pricing benchmarks, and as a collateral source). Clarity and consistency are necessary conditions for the proper pricing of sovereign risk. Beyond that, the proper pricing of sovereign risk has implications for the economy as a whole (via the impact on risk-weight rules for capital adequacy of banks, posting sovereign debt as collateral, the pricing of bonds issued by banks and other non-governmental entities). The transition from a (relatively) “risk-free asset” to a (relatively) “risky asset” has therefore major macro and micro financial ramifications.

Suggested Citation

  • Hans J. Blommestein, 2012. "The Debate over Sovereign Risk, Safe Assets, and the Risk-Free Rate: What are the Implications for Sovereign Issuers?," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 1(3), pages 55-70, September.
  • Handle: RePEc:tek:journl:v:1:y:2012:i:3:p:55-70
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    File URL: http://ekonomitek.org/pdffile/no3_hans_j_blommestein.pdf
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    References listed on IDEAS

    as
    1. Blommestein, Hans J. & Eijffinger, Sylvester C W & Qian, Zongxin, 2012. "Animal Spirits in the Euro Area Sovereign CDS Market," CEPR Discussion Papers 9092, C.E.P.R. Discussion Papers.
    2. 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.
    3. Hans J. Blommestein & Vincenzo Guzzo & Allison Holland & Yibin Mu, 2010. "Debt Markets: Policy Challenges in the Post-Crisis Landscape," OECD Journal: Financial Market Trends, OECD Publishing, vol. 2010(1), pages 143-169.
    4. Ang, Andrew & Longstaff, Francis A., 2013. "Systemic sovereign credit risk: Lessons from the U.S. and Europe," Journal of Monetary Economics, Elsevier, vol. 60(5), pages 493-510.
    Full references (including those not matched with items on IDEAS)

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    Cited by:

    1. Beniamino Moro, 2013. "The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. The US," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 2(1), pages 41-77, January.

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    More about this item

    Keywords

    Risk-Free Rate; Safe Assets; Sovereign Risk; Mispricing; Sovereign Issuers;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt
    • H68 - Public Economics - - National Budget, Deficit, and Debt - - - Forecasts of Budgets, Deficits, and Debt

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