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Default risk and risk averse international investors

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  • Lizarazo, Sandra Valentina
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    Abstract

    This paper develops an endogenous default risk model for small open economies that interact with risk averse international investors whose preferences exhibit decreasing absolute risk aversion (DARA). By incorporating risk averse investors who trade with an emerging economy, the present model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets than the standard model with risk neutral investors. The paper shows that if investors have DARA preferences, then the emerging economy's default risk, capital flows, and bond prices are a function not only of the fundamentals of the economy but also of the level of financial wealth and risk aversion of international investors. In particular, as investors become wealthier or less risk averse, the emerging economy becomes less credit constrained. As a result, the emerging economy's default risk is lower, and its bond prices and capital inflows are higher. Additionally, with risk averse investors, the risk premium in the asset prices of the sovereign countries can be decomposed into two components: a base premium that compensates the investors for the probability of default and an “excess” premium that compensates them for taking the risk of default.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0022199612001511
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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of International Economics.

    Volume (Year): 89 (2013)
    Issue (Month): 2 ()
    Pages: 317-330

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    Handle: RePEc:eee:inecon:v:89:y:2013:i:2:p:317-330

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    Web page: http://www.elsevier.com/locate/inca/505552

    Related research

    Keywords: Sovereign default; International investors; Risk aversion;

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    Cited by:
    1. Guimaraes, Bernardo & Iazdi, Oz, 2013. "IMF conditionalities, liquidity provision, and incentives for fiscal adjustment," MPRA Paper 48896, University Library of Munich, Germany.
    2. Akıncı, Özge, 2013. "Global financial conditions, country spreads and macroeconomic fluctuations in emerging countries," Journal of International Economics, Elsevier, vol. 91(2), pages 358-371.
    3. Ludwig, Maximilian, 2013. "Government Debt and Default in a Minimal State," Working Papers 30/2013, Universidade Portucalense, Centro de Investigação em Gestão e Economia (CIGE).
    4. Michael Kumhof & Romain Ranciere & Pablo Winant, 2013. "Inequality, Leverage and Crises: The Case of Endogenous Default," IMF Working Papers 13/249, International Monetary Fund.
    5. Cristina Arellano & Yan Bai, 2013. "Linkages across sovereign debt markets," Staff Report 491, Federal Reserve Bank of Minneapolis.

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