Predictability in Emerging Sovereign Debt Markets
I find strong evidence of economically and statistically significant predictability in Brady bonds, the most liquid emerging debt market, by implementing a new model for credit spreads. Active management provides U.S. investors in emerging markets with double the buy-and-hold returns at lower risk and the equivalent of free options on Brady bonds. My analysis suggests that predictability is primarily driven by credit spread deviations from fundamentals rather than time-varying risk or risk premia. This inefficiency results from the restrictions of a nontransparent, institutionally dominated, dealer market and the lack of a fully developed derivatives market for emerging country credit risk.
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