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Ambiguity and Time-Varying Risk Aversion in Sovereign Debt Markets

Christoph Große Steffen and Maximilian Podstawski

No 1602, Discussion Papers of DIW Berlin from DIW Berlin, German Institute for Economic Research

Abstract: This paper introduces changes in the level of ambiguity as a complementary source of time-varying risk aversion. We show in a consumption-based asset pricing model with simultaneously risky and ambiguous assets that a rise in the level of ambiguity raises investors' risk aversion. The effect is quantified in an application to European sovereign debt markets using a structural VAR to achieve identification in the data. We proxy for ambiguity using a measure of macroeconomic uncertainty and decompose empirically credit default swaps (CDS) for Spain and Italy into three shocks: fundamental default risk, risk aversion, and uncertainty. We find that shocks to uncertainty significantly increase international investors' risk aversion, accounting for about one fifth of its variation at a five week horizon, and have a significant and economically relevant impact on sovereign financing premia

Keywords: Time-varying risk aversion; Ambiguity; Uncertainty; Sovereign debt; Identification via heteroscedasticity; Maxmin (search for similar items in EconPapers)
JEL-codes: C32 D80 E43 G01 H63 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-eec, nep-fmk, nep-mac, nep-ore and nep-upt
Date: 2016
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