Judge the way geopolitical shocks feed into the premiums demanded for holding sovereign risk.
The idea
A sovereign spread is the yield on a government bond minus the yield on a risk-free benchmark. It compensates for two things, expected loss from default and a risk premium for bearing that risk. Using the credit triangle, the spread is approximately the following. Spread = default probability × (1 − recovery rate). Geopolitical shocks widen sovereign spreads, mainly through a higher risk premium and some increase in perceived default risk. The effect is larger for emerging markets and for countries with high debt, weak ratings or thin reserves. Safe-haven sovereigns can see yields fall, which widens spreads measured against them even if the local yield is unchanged. A common error is reading a market-implied default probability from CDS as a real-world probability. It is risk-neutral and includes the premium, so it overstates physical default risk.
Formulas
Credit triangle for a sovereign or CDS spread
spread ≈ λ × (1 − R)
- spread
- the sovereign or CDS spread over the risk-free rate
- λ
- the annual default probability
- R
- the recovery rate
Solved for λ from a CDS spread it gives a risk-neutral probability that includes the risk premium, so it overstates the real-world default probability.
A practice question
What is a sovereign spread?
- The difference between a country's inflation rate and its policy rate.Why not: A macroeconomic gap, not a bond yield spread measuring compensation for sovereign risk.
- The yield on a government bond divided by that country's GDP growth rate.Why not: A ratio unrelated to compensation for credit risk over a benchmark.
- The yield on a government bond minus the yield on a risk-free benchmark of the same maturity. - correct
- The difference between bid and ask yields on the government bond.Why not: Describes trading cost (liquidity), not credit and geopolitical risk compensation.
A sovereign spread is the excess of a government's yield over a risk-free benchmark and compensates for default risk and for bearing that risk.
A harder one
An emerging market bond yield rises from 7.00% to 7.20%. Because of safe-haven flows, the benchmark U.S. Treasury yield falls from 4.00% to 3.70%. The change in the spread over the benchmark is closest to:
- +20 bpWhy not: Counts only the change in the emerging market yield and ignores the lower benchmark.
- +30 bpWhy not: Counts only the fall in the benchmark and ignores the rise in the local yield.
- +50 bp - correct
- -10 bpWhy not: Subtracts the two yield changes in the wrong direction, mixing up the sign of the benchmark move.
Spread before = 3.00%, after = 7.20% - 3.70% = 3.50%. The change is +50 bp, which combines the 20 bp rise in the local yield and the 30 bp fall in the safe benchmark.
The hardest tier
A sovereign's spread is 400 bp. The physical default probability is 2.5% and loss given default is 60%, so expected loss is 150 bp and the remainder is a risk premium. After a geopolitical shock the spread is 520 bp and the physical default probability is 3.5% with the same loss given default. How much of the 120 bp widening is due to the risk premium?
- 120 bpWhy not: Attributes the entire widening to the risk premium and ignores the rise in expected loss.
- 310 bpWhy not: Reports the level of the new risk premium instead of its change.
- 210 bpWhy not: Reports the new expected loss rather than the part of the widening explained by the premium.
- 60 bp - correct
Initial premium = 400 - 150 = 250 bp. New expected loss = 3.5% x 60% = 210 bp, so the new premium = 520 - 210 = 310 bp. The premium rose by 60 bp and expected loss rose by 60 bp: the widening is half premium.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Global Financial Stability Report, Chapter 2
- Pinpoint the main routes by which geopolitical risk moves asset prices and affects financial stability, and review policy responses to its possible fallout.
- Examine why geopolitical risk events worldwide leave different marks on individual countries, industries and asset classes, notably separating net commodity importers from exporters.
- Judge how stock markets reacted to various domestic and global geopolitical risk events, such as Russia's invasion of Ukraine and U.S.-China trade tensions, and account for their spillovers across borders.
- Show how equity and option markets price in geopolitical risk, including shifts in downside risk and tail-risk premiums.
- Outline how being exposed to geopolitical risk shapes how well banks and non-bank financial firms hold up, through share valuations, credit supply and flows into investment funds.