Neglected Risk: Evidence from the Eurozone Sovereign Credit Market

Abstract

We find evidence of neglected risk during sovereign debt expansions (DE), by analyzing the sovereign debt markets for both crisis and non-crisis Eurozone countries from 2002-2017. After showing that DE predicts increased default probability, we first provide initial evidence that conditional on large DE, future risk premia are negative. Second, we document the negative relation between DE and future risk premia in a panel regression framework. Third, we document the impact that the Deauville summit in October 2010 had on neglected risk, by using panel regressions one year before and after this event. Our results provide evidence of neglected risk before, but not immediately after Deauville. Finally, analyzing the most recent data (2012-2017) we show that DE still predicts lower risk premia, however this effect is neutralized by quantitative easing (QE), therefore raising the public policy question of what will happen after QE ends.

Keywords: Risk premia, debt expansion, CDS spreads, sovereign debt, Deauville, Quantitative easing

JEL Classification: E52, E58, G41, H30, H63