This study sought to build a novel and comprehensive sovereign default risk model and to prove that there is reflexivity between asset prices and their fundamental factors. The first real finding in this study was that sovereign defaults are mostly individual events by nature and a ubiquitous model cannot and should not be constructed to assess sovereign default risk. Instead they are often strategic choices made by the governments in time specific environments, with participating investors as decisions makers on the other side, their actions limited by the boundaries of the time specific alternative asset and investment space.
The goal of this study is to provide information about the suitability of static asset pricing models. The hypothesis of the paper have been set as follows:
1) Interest rate change (change in asset price) can affect the underlying fundamentals
2) because of 1) there is reverse causality between asset prices and the relative fundamentals
3) because of 2) static asset pricing and credit risk models are insufficient tools 4) because of 3) we need dynamic asset pricing models, which can take in to
account the reflexive nature of the relationship between asset prices and their underlying fundamentals
Though scientifically more rigorous, this study did not aim to refute it’s own claims.
This was partly because these claims are addressed in modern economics as if they had been refuted earlier. Instead the refutation of assumptions currently prevailing in financial economics became to the goal, as confirming hypothesis 1) de facto eliminates the possibility of considering asset prices as mere results of their fundamental factors.
As the relation with YIELD and GDP_GROWTH clearly indicate, asset prices can affect their underlying fundamentals, with statistical significance. Therefore Hypothesis 1) can not be rejected. Bi-directionality was also found between bond
hypothesis itself. As hypothesis 2) can neither be rejected, the argument is laid out in such a manner that too wide generalizations should be avoided. One can summarize by stating that, though changes in government borrowing rates most probably affected Greek fundamental factor as the country was forced to austerity measures, it does not confirm, that this is the case always and everywhere.
Logically, not rejecting 2) leads to confirming 3) at least partly. As asset prices can affect their fundamentals, in some instances static asset pricing models can be somewhat insufficient and at least some dynamic aspects should be incorporated in the models, confirming 4). Or there is the possibility of not developing better tools for valuation, which would not be very surprising considering that the finance industry still relies heavily on models that have been proved either inconsistent with reality eg.
Beta based approaches or insufficient in depicting the uncertainty they are designed to model eg. Black & Scholes approaches.
As the findings of this paper are rather straight forward, the final part of this paper seeks to illustrate the very events where these findings and their implications may be relevant.
Naturally sovereign debt crisis and other credit events involving changes in investor confidence, dynamic models could help to assess and evaluate the risks of loosing confidence. This is especially important for two reasons 1) bond holder losses suffered by evaporating confidence are partly self-imposed 2) the monetary risk of loosing confidence hardly is a linear function of increasing credit risk, which makes the assessment of these risks very difficult with modern valuation tools.
Another instance where dynamic asset pricing models would be useful are, IPO’s. As some offerings become hyped and lead to repeated increases in the eventual offer price preceding the IPO event, the offer price increases can become self-fueling. This is somewhat understandable at least in cases where the IPO proceeds are used for buying other companies. The more money raised, the more capacity to make even more money by buying companies from the market.
Third, somewhat more incremental illustration can be an example of a company, which’ share price has increased steadily, perhaps more than the fundamental valuation would preliminary suggest. This rise can, though affect the very fundamentals, as the share price increases, so does the market value of the company’s equity. This in turn, may lead to a reduction in debt financing costs, which are an integral part of fundamental valuation trough WACC for example.
The common factor in the above example is movement in an asset’s price. Therefore the natural benefit of non-static asset pricing models would be the ability to explain momentum, often witnessed in asset values.
This study has revised a vast dataset extending back decades and performed a case study with recent data. Unsurprisingly there have been results that are as expected and there have been those that are not. Some findings of this paper are more important than others, but the most important are the findings in future studies, inspired by this paper.
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Appendix 1 - Impulse Responses in VAR model
Appendix 2 - Variance decomposition in VAR model
Appendix 3 - Yield Equation OLS
Variable Coefficient Std. Error t-Statistic Prob.
C -0.025271 0.086560 -0.291947 0.7716
GDP_GROWTH -0.723532 0.244824 -2.955311 0.0048 GOV_REVE_TO_DEBT 0.303656 0.260482 1.165748 0.2494 SPASEXRATE 0.066732 0.030599 2.180808 0.0340 R-squared 0.581328 Mean dependent var 0.079046 Adjusted R-squared 0.555695 S.D. dependent var 0.065633 S.E. of regression 0.043749 Akaike info criterion -3.348240 Sum squared resid 0.093783 Schwarz criterion -3.199539 Log likelihood 92.72835 Hannan-Quinn criter. -3.291056 F-statistic 22.67890 Durbin-Watson stat 0.352208 Prob(F-statistic) 0.000000
Appendix 4 - GDP Growth Equation OLS Dependent Variable: GDP_GROWTH Method: Least Squares
Date: 11/08/14 Time: 16:01 Sample (adjusted): 2001Q1 2014Q2 Included observations: 54 after adjustments
Variable Coefficient Std. Error t-Statistic Prob.
C 0.086405 0.009265 9.325981 0.0000
CAPITAL_FORMATION 0.899480 0.126956 7.084986 0.0000 UNEMPLOYMENT -0.359263 0.072313 -4.968184 0.0000 YIELD -0.134923 0.080139 -1.683624 0.0985 R-squared 0.836962 Mean dependent var 0.022372 Adjusted R-squared 0.827179 S.D. dependent var 0.063038 S.E. of regression 0.026206 Akaike info criterion -4.374484 Sum squared resid 0.034337 Schwarz criterion -4.227152 Log likelihood 122.1111 Hannan-Quinn criter. -4.317664 F-statistic 85.55883 Durbin-Watson stat 0.848096 Prob(F-statistic) 0.000000
Appendix 5 GDP Growth with omitted variable
Variable Coefficient Std. Error t-Statistic Prob.
C 0.081780 0.010009 8.170514 0.0000
CAPITAL_FORMATION 0.841721 0.141229 5.959996 0.0000 UNEMPLOYMENT -0.359784 0.076060 -4.730274 0.0000
YIELD -0.118672 0.085429 -1.389125 0.1725
CURRENT_ACCOUNT_CHANGE 0.014528 0.011108 1.307975 0.1983
R-squared 0.832184 Mean dependent var 0.011940
Adjusted R-squared 0.815402 S.D. dependent var 0.063949 S.E. of regression 0.027475 Akaike info criterion -4.246610 Sum squared resid 0.030196 Schwarz criterion -4.045870 Log likelihood 100.5487 Hannan-Quinn criter. -4.171776
F-statistic 49.58906 Durbin-Watson stat 0.873521
Prob(F-statistic) 0.000000
Appendix 6 - Yield Equation reduced form OLS Dependent Variable: YIELD
Method: Least Squares Date: 11/08/14 Time: 16:21 Sample (adjusted): 2001Q1 2014Q1 Included observations: 53 after adjustments
Variable Coefficient Std. Error t-Statistic Prob.
C 0.028874 0.088678 0.325600 0.7461
CAPITAL_FORMATION -0.597621 0.292443 -2.043550 0.0465 UNEMPLOYMENT 0.429327 0.295575 1.452512 0.1529 GOV_REVE_TO_DEBT -0.035084 0.210858 -0.166388 0.8686 SPASEXRATE 0.007804 0.063517 0.122867 0.9027 R-squared 0.549661 Mean dependent var 0.079046 Adjusted R-squared 0.512132 S.D. dependent var 0.065633 S.E. of regression 0.045843 Akaike info criterion -3.237590 Sum squared resid 0.100877 Schwarz criterion -3.051714 Log likelihood 90.79614 Hannan-Quinn criter. -3.166111 F-statistic 14.64656 Durbin-Watson stat 0.256619 Prob(F-statistic) 0.000000
Appendix 7 - GDP Growth reduced form OLS Dependent Variable: GDP_GROWTH Method: Least Squares
Date: 11/08/14 Time: 16:32 Sample (adjusted): 2001Q1 2014Q2 Included observations: 54 after adjustments
Variable Coefficient Std. Error t-Statistic Prob.
C 0.097902 0.013860 7.063721 0.0000 CAPITAL_FORMATION 1.088135 0.133960 8.122810 0.0000 UNEMPLOYMENT -0.611245 0.157969 -3.869388 0.0003 SPASEXRATE 0.047625 0.034807 1.368250 0.1774 R-squared 0.833937 Mean dependent var 0.022372 Adjusted R-squared 0.823973 S.D. dependent var 0.063038 S.E. of regression 0.026448 Akaike info criterion -4.356099 Sum squared resid 0.034974 Schwarz criterion -4.208767 Log likelihood 121.6147 Hannan-Quinn criter. -4.299279 F-statistic 83.69660 Durbin-Watson stat 0.855854 Prob(F-statistic) 0.000000