The pricing of sovereign risk in emerging markets: fundamentals and risk aversion

December 2006

Abstract

We propose a dynamic market-based measure of sovereign risk and use it to decompose sovereign credit default swap (CDS) spreads into, first, expected losses from default and, second, the risk premia required by investors as compensation for default risk. Doing so reveals that country-specific fundamentals primarily drive sovereign risk whilst global investors' risk aversion drives time variation in risk premia. Consistent with this, we find the sovereign risk premia is more highly correlated than sovereign risk itself in emerging markets. These results help us to explain the remarkable narrowing of emerging market spreads between 2002 and 2006.