Risk and uncertainty in euro area sovereign debt markets and their impact on economic activity

Anna Grochowska, Plamen Nikolov and Rafal Raciborski

Quarterly Report on the Euro Area (QREA), 2012, vol. 11, issue 4, 31-38

Abstract: Risk and uncertainty are two important concepts in economics and finance. Risk is understood to be measurable, while uncertainty is not. (57) Finance and economics have traditionally emphasised the role of quantifiable risk. For example, in modern portfolio theory risk is calculated using statistical probability of asset returns. Another example is borrower default risk, which is estimated by credit score calculations including quantitative elements. The word uncertainty, on the other hand, is often used to describe situations where risks are difficult to quantify, for instance because the chances that they occur are extremely slim. The financial crisis has refocused attention on so-called ëtail risksí, which relate to events with little historical record of occurrence and unknown (but potentially large) impact. Tail risks are, therefore, to a large extent immeasurable. When the presence of incalculable uncertainty is acknowledged, investors start hoarding liquidity for self-insurance and drive up risk premia. (58) Both calculable risk and uncertainty are present in risk premium determination and thus affect economic activity. For example, during the precrisis years lower risk premia contributed to keeping long-term interest rates down and supported housing markets and consumer spending. Conversely, risk premia have surged in some countries since the onset of the crisis, with a negative impact on the economy. The purpose of this section is to shed some light on the drivers of the changes in risk premia since the crisis. It first reviews a number of indicators of measurable risk and immeasurable uncertainty. It then quantifies the relationship between euro area sovereign bond spreads and their determinants, trying to identify the respective roles of calculable risk and uncertainty. Last, the (57) There is a body of literature on the difference between the two concepts; see Knight, F. (1921): Risk, uncertainty and profit, Boston: Houghton Mifflin, on the concept of Knightian uncertainty, and Ellsberg, D. (1961): Risk, ambiguity, and the savage axioms, The Quarterly Journal of Economics Vol. 75, No 4, on its application in finance. (58) Risks arising from financial crises are difficult to insure because often it is impossible to calculate the likelihood of a crisis. Moreover, the consequences of a crisis are frequently modified by those affected. Hence it is difficult to determine whether the crisis is the cause or the consequence. section investigates the impact of falling sovereign risk premia on the real economy, including spillover effects into the corporate bond market.

Keywords: economic risk and uncertainty; sovereign debt markets (search for similar items in EconPapers)
Date: 2012
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