The Dynamic Pricing of Sovereign Risk in Emerging Markets

TLDR

The article proposes a novel sovereign risk pricing framework that uses sovereign CDS spreads. It estimates a dynamic market‑based sovereign risk metric and decomposes CDS spreads into expected default losses and investor‑required risk premia. The study finds that country fundamentals dominate sovereign risk, while global risk aversion drives risk‑premia dynamics, and that risk premia are more correlated within emerging‑market regions, explaining the 2002‑2006 spread narrowing and contagion channel. Topics: emerging markets, credit default swaps, credit risk management, statistical methods.

Abstract

This article 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 while global investors9 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. <b>TOPICS:</b>Emerging markets, credit default swaps, credit risk management, statistical methods