The World Price of Credit Risk
48 Pages Posted: 17 Mar 2012
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The World Price of Credit Risk
Date Written: January 15, 2012
Abstract
Global asset-pricing models have failed to capture the cross section of country equity returns. Emerging markets have displayed strikingly large and robust positive pricing errors. Country-level characteristics have played a significant role in pricing international equities, suggesting that financial markets may not be fully integrated. This paper offers a risk-based explanation that resolves these deviations from global asset pricing. A world credit risk factor explains the positive pricing errors in emerging market equities. Moreover, in the presence of this credit risk factor, country-level characteristics no longer play a role in pricing global equities. Factor models that include the world credit risk factor uniformly outperform, both in the time-series and the cross-section, competing specifications that exclude this factor. Over the 1989-2009 period, the risk premium for systematic credit risk exposure is 83 basis points per month and its importance has dramatically increased in recent years.
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