The World Price of Credit Risk

Abstract

Global asset pricing models have failed to capture the cross section of country equity returns. Emerging markets display robust positive pricing errors and country-level characteristics play a role in pricing international equities. This paper offers a risk-based explanation for such asset pricing deviations. A world credit risk factor is significantly priced in the cross section of country equity returns. In its presence, the positive pricing errors in emerging markets disappear and country-level characteristics no longer play a role. The risk premium for exposure to the credit risk factor is 80 basis points per month and has increased in recent years.

Keywords: sovereign credit risk, credit rating, emerging markets, international asset-pricing, market efficiency

JEL Classification: G12, G14, G15