Credit Risk Pricing in Emerging Markets During Elections: Time Inconsistency and Forward Looking Uncertainty

60 Pages Posted: 13 Mar 2010 Last revised: 6 Apr 2010

Date Written: March 13, 2010

Abstract

To study the role of elections in financial market instability, we focus on the role of credit risk pricing during elections from 2004 to 2007 in thirteen emerging market economies. We use a unique dataset of daily credit default swap (CDS) pricing, with standard macroeconomic controls, to study the role of elections in prompting financial market instability and contagion. Sovereign credit default swap pricing provides a number of advantages in understanding emerging market instability of previous studies. First, the daily data allows a greater level of specificity than was used in previous credit and political studies. Second, even though sovereign credit conditions change slowly, CDS pricing changes daily, reflecting sentiment or forward looking beliefs. Third, the CDS allows us to focus on the perceived credit risk of an election and the incoming government.

Our study reveals a number of unique findings. First, investors price in additional risk for elections regardless of party, incumbency, or size of win. Second, long and short term investors price risk very differently, with 1 year CDS investors reacting much more strongly to election risk, causing the overall spread to narrow. Third, our results provide continued support for the theory of investor herding in international financial markets, and a focus on a small number of economic variables in determining sovereign credit worthiness. Investors do not study the relative risk factors as much as price in structural risk by the existence of definable benchmarks like elections.

Keywords: Emerging Markets, Credit Default Swaps, Sovereign Debt, Elections

JEL Classification: D72, F34, G15

Suggested Citation

Balding, Christopher, Credit Risk Pricing in Emerging Markets During Elections: Time Inconsistency and Forward Looking Uncertainty (March 13, 2010). Available at SSRN: https://ssrn.com/abstract=1570044 or http://dx.doi.org/10.2139/ssrn.1570044

Christopher Balding (Contact Author)

Fulbright University Vietnam ( email )

Vietnam

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