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This paper seeks to dispel or at least reduce the confusion surrounding the related key concepts of the risk-free rate, safe assets, and sovereign risk, which are central to policy and academic discussions. This confusion gives rise to a lack of consensus as to how to define, measure, and price “sovereign risk,” thus creating a major obstacle to assessing sovereign borrowers’ stress. In this paper, safe assets are considered to be those that are virtually default- free. These so-called safe assets function as “information-insensitive” instruments (they serve as “money” and have the associated basic functions of money, such as collateral and backing of checkable deposits of commercial banks and money-market funds). The return on these assets is the (relatively) risk-free rate. The pricing of risky assets involves assessing or evaluating the risk dimensions of relative asset safety. A significant complication in carrying this out is the fact that the market is often driven by emotions, or animal spirits. Sometimes these market emotions change rapidly, having a knock-on effect on the (mis)pricing of relatively safe assets and sovereign risk. The track record of sovereign-risk pricing is not very impressive, characterized by prolonged periods of risk under-pricing (excessively compressed spreads) followed by risk overpricing (sudden widening of spreads). Market measurements (including ratings) thus seem somewhat unreliable. One should, therefore, be extremely cautious in concluding that the sovereign debt of an OECD country has indeed lost its “risk-free” status. At the same time, the overarching strategic objective of debt managers is to raise funds at the lowest possible cost within the boundaries of a preferred risk level. This implies for the sovereign borrower a two-part goal: issuing (relatively) risk-free sovereign debt and preserving this relatively risk-free status. Reinforcing government borrowers’ focus on this strategic objective is the knowledge that a steady supply of safe sovereign assets is essential for the smooth functioning of the worldwide financial system (for allocating resources, pricing benchmarks, and as a collateral source). Clarity and consistency are necessary conditions for the proper pricing of sovereign risk. Beyond that, the proper pricing of sovereign risk has implications for the economy as a whole (via the impact on risk-weight rules for capital adequacy of banks, posting sovereign debt as collateral, the pricing of bonds issued by banks and other non-governmental entities). The transition from a (relatively) “risk-free asset” to a (relatively) “risky asset” has therefore major macro and micro financial ramifications.

We study the determinants for the sovereign credit default swap (CDS) spreads of five Euro-area countries (Greece, Ireland, Italy, Portugal, Spain) in the post-Lehman-Brothers period. We find that there are regime switches in the process of sovereign CDS spread changes. We consider three alternative empirical hypotheses associated with regime switches. Under the first hypothesis, there are rational sunspot equilibria. Under the second hypothesis, there is a unique fundamental equilibrium and the regime switching is caused by changes in policy makers' preferences. The third hypothesis relaxes the rational expectations assumption. Under this hypothesis, indicators of the market fundamentals are not always precise. They are better indicators if cognitive biases are small and the rational expectations economy is a good approximation for reality. However, if market uncertainties enlarge the cognitive biases, the market-based indicators of fundamentals are no longer precise. In this case, they are not useful for CDS pricing. We find that the first two hypotheses are difficult to fit the data and the third hypothesis provides a good explanation for the sovereign CDS spread dynamics in our sample.

This paper builds a dynamic general equilibrium macro-finance model with two types of borrowers: entrepreneurs who want to produce and gamblers who want to play a lottery. It links central bank's interest rate policy to expected cash flows of both types. This link enables us to study how the interactions between various shocks and different monetary policy rules affect the borrower pool faced by financial intermediaries. We find that when the economy is hit by an expansionary monetary policy shock, the proportion of entrepreneurs in the borrower pool will be persistently lower than the steady state level after a short period. It is lowest when the central bank does not react to output fluctuations. Quite differently, not reacting to output fluctuations avoids a persistent worsening of the borrower pool in the long run if the shock is a bad productivity shock.

On September 3-4, 2009 SUERF and Utrecht University School of Economicsorganized the Colloquium "The Quest for Stability" in Utrecht, the Netherlands. The papers included in this SUERF Study are based on contributions to the Colloquium.