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Sovereign default risk and uncertainty premia

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  • Demian Pouzo
  • Ignacio Presno
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    Abstract

    This paper studies how foreign investors' concerns about model misspecification affect sovereign bond spreads. We develop a general equilibrium model of sovereign debt with endogenous default wherein investors fear that the probability model of the underlying state of the borrowing economy is misspecified. Consequently, investors demand higher returns on their bond holdings to compensate for the default risk in the context of uncertainty. In contrast with the existing literature on sovereign default, we explain the bond spreads dynamics observed in the data as well as other business cycle features for Argentina, while preserving the default frequency at historical low levels.

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    File URL: http://www.bostonfed.org/economic/wp/wp2012/wp1211.htm
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Boston in its series Working Papers with number 12-11.

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    Date of creation: 2012
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    Handle: RePEc:fip:fedbwp:12-11

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    Keywords: Bonds ; Debts; External;

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    1. Emine Boz & Christian Daude & C. Bora Durdu, 2011. "Emerging Market Business Cycles Revisited: Learning about the Trend," Koç University-TUSIAD Economic Research Forum Working Papers 1110, Koc University-TUSIAD Economic Research Forum.
    2. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
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    8. Rohan Pitchford & Mark L. J. Wright, 2010. "Holdouts in Sovereign Debt Restructuring: A Theory of Negotiation in a Weak Contractual Environment," NBER Working Papers 16632, National Bureau of Economic Research, Inc.
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    16. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    17. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 13(4), pages 919-933, October.
    18. Pablo A. Neumeyer & Fabrizio Perri, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," NBER Working Papers 10387, National Bureau of Economic Research, Inc.
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    21. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models: Solution Methods Matter," IMF Working Papers 10/100, International Monetary Fund.
    22. Boz, Emine & Daude, Christian & Bora Durdu, C., 2011. "Emerging market business cycles: Learning about the trend," Journal of Monetary Economics, Elsevier, vol. 58(6), pages 616-631.
    23. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    24. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
    25. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
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