The Debate on Sovereign Risk, Safe Assets and the Risk-Free Rate: What are Possible Implications for Sovereign Issuers?
Ekonomi-tek, Volume 1, No. 3, p. 55, September 2012
17 Pages Posted: 15 Apr 2013
Date Written: September 14, 2012
Abstract
This paper seeks to eliminate or reduce confusions about (related) key concepts such as the risk free rate, safe assets and sovereign risk in policy and academic discussions. A lack of consensus and confusions on how to define, measure and price “sovereign risk” is an important obstacle in assessing sovereign stress.
Safe assets are considered to be virtually default-free in this paper. These so-called safe assets function as so-called information-insensitive instruments (they serve as money with associated basic functions of money such as collateral and backing of checkable deposits of commercial banks and money market funds). The return on these assets is the (relatively) risk free rate.
Pricing of risky assets involves assessing or evaluating the risk dimensions of relative asset safety. A major complication is that the market is often driven by emotions or animal spirits. Sometimes emotions change rapidly, having an important impact on the (mis)pricing of relative safe assets and sovereign risk. The track-record of sovereign risk pricing is not very impressive with prolonged period of risk underpricing (excessively compressed spreads), followed by risk overpricing (sudden widening of spreads). Market measures (including ratings) seem therefore not very reliable. One should, therefore, be very cautious in concluding that the sovereign debt of an OECD country has indeed lost its risk-free status. The strategic core objective of debt managers is to raise funds at lowest possible costs subject to a preferred risk level. This implies for the sovereign: issuing (relatively) risk free sovereign debt and guarding this relatively risk free status. This objective is further supported by the importance of the supply of safe sovereign assets for the functioning of the financial system (for allocating resources, pricing benchmarks, and as a collateral source).
Clarity and consistency are necessary conditions for the proper pricing of sovereign risk. The proper pricing of sovereign risk has also implications for the economy as a whole (via the impact on risk-weight rules for capital adequacy of banks, posting sovereign debt as collateral, the pricing of bonds issued by banks and other non-governmental entities). The transition from a (relatively) risk-free asset to a (relatively) risky asset has therefore major macro and micro financial implications.
Keywords: Risk Free Rate, Safe Assets, Sovereign Risk, Mispricing, Sovereign Issuers
JEL Classification: E43, E61,E62, F34, G18, H63, H68
Suggested Citation: Suggested Citation
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