The Dynamic Pricing of Sovereign Risk in Emerging Markets: Fundamentals and Risk Aversion

TLDR

The paper proposes a novel sovereign risk pricing framework grounded in sovereign CDS spreads. The authors estimate a dynamic market‑based sovereign risk metric and decompose sovereign CDS spreads into expected default losses and risk‑premia demanded by investors. The study finds that country fundamentals dominate sovereign risk, while global risk aversion explains the temporal variation of risk premia, with risk premia showing stronger regional correlation and accounting for the 2002‑2006 spread convergence and contagion dynamics.

Abstract

This paper introduces a new approach to pricing sovereign risk based on sovereign credit default swap (CDS) spreads. We estimate a dynamic market-based measure of sovereign risk and use it to decompose sovereign CDS spreads into expected losses from default and the market risk premia required by investors as compensation for default risk. Using a dynamic panel data model, we find that country-specific fundamentals primarily drive sovereign risk whilst global investors' risk aversion drives time variation in the risk premia. Consistent with this, we also find that the sovereign risk premia is more highly correlated than sovereign risk itself within emerging market regions. These results help us to explain the remarkable narrowing of emerging market spreads between 2002 and 2006 and to understand the pricing mechanism and channel of contagion for emerging debt markets.