Determinants of market-assessed sovereign risk: Economic fundamentals or market risk appetite?

This paper examines the determinants of the market-assessed sovereign risk premium, measured by the Brady bond stripped yield spread. Our study shows that, while standard economic fundamentals of a sovereign significantly affect the bond yield spread, the market's attitude towards risk is another important determinant. We construct a measure of the market's attitude towards risk called the risk appetite index (RAI), and find that for comparable changes in all the economic variables the RAI has a relatively large impact on the Brady bond yield spread. Our results explain why there is contagion in the Brady bond market and why often there is a divergence between the market's perception of the country risk premium and published ratings on sovereign creditworthiness.