Global factors and the pricing of sovereign risk

Abstract

I study the effects of US Macroeconomic surprises on the pricing of sovereign risk of sixty-six countries in the period 2002-2017 using daily CDS data. I also explore how a country spread's sensitivity to these shocks depends on a wide range of country characteristics. I discuss potential transmission mechanisms of sovereign distress to the real economy by studying the cross-sectional response of security prices (corporate CDS spreads and stock returns) to global shocks. I find that positive macroeconomic surprises in the US systematically reduce sovereign spreads consistent with the view that global investors price sovereign risk. However, I find that both the size and the sign of the effect depend on the business cycle in the US. During contractionary periods the positive effect of news is greatly reduced, often erased, and sometimes reversed. I also find evidence of asymmetric and non-linear effects. Moreover, I find that country characteristics such as its credit rating, its debt-to-GDP ratio, and measures of economic integration play a crucial role in determining the country's response to US shocks.