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




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Financial theory and practice, Vol.34 No.3 September 2010. -

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.

country risk; credit default swaps; credit ratings; cross-border flows; financial crisis; central and eastern Europe; foreign-owned banks



Author: Debora Revoltella - Fabio Mucci - Dubravko Mihaljek -

Source: http://hrcak.srce.hr/



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