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Sovereign default risk and uncertainty premia

  • Demian Pouzo
  • Ignacio Presno
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    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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    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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    1. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
    2. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    3. 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.
    4. Leonardo Martinez & Juan Carlos Hatchondo & Cesar Sosa Padilla, 2011. "Debt Dilution and Sovereign Default Risk," IMF Working Papers 11/70, International Monetary Fund.
    5. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
    6. Pablo Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report 335, Federal Reserve Bank of Minneapolis.
    7. Uribe, Martin & Yue, Vivian Z., 2006. "Country spreads and emerging countries: Who drives whom?," Journal of International Economics, Elsevier, vol. 69(1), pages 6-36, June.
    8. Rohan Pitchford & Mark L. J. Wright, 2012. "Holdouts in Sovereign Debt Restructuring: A Theory of Negotiation in a Weak Contractual Environment," Review of Economic Studies, Oxford University Press, vol. 79(2), pages 812-837.
    9. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
    10. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Macroeconomic Risk," American Economic Review, American Economic Association, vol. 97(2), pages 1-30, May.
    11. 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.
    12. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Economic Risk," NBER Working Papers 12948, National Bureau of Economic Research, Inc.
    13. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
    14. Lizarazo, Sandra, 2010. "Default Risk and Risk Averse International Investors," MPRA Paper 20794, University Library of Munich, Germany.
    15. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates and the current account," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    16. 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.
    17. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
    18. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
    19. Emine Boz & Christian Daude & Ceyhun Bora Durdu, 2008. "Emerging market business cycles revisited: learning about the trend," International Finance Discussion Papers 927, Board of Governors of the Federal Reserve System (U.S.).
    20. Mark Aguiar & Gita Gopinath, 2004. "Emerging market business cycles: the cycle is the trend," Working Papers 04-4, Federal Reserve Bank of Boston.
    21. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
    22. Enrique G. Mendoza & Vivian Z. Yue, 2008. "A Solution to the Disconnect between Country Risk and Business Cycle Theories," NBER Working Papers 13861, National Bureau of Economic Research, Inc.
    23. Robert J. Barro, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," The Quarterly Journal of Economics, Oxford University Press, vol. 121(3), pages 823-866.
    24. 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.
    25. Young, Eric R., 2012. "Robust policymaking in the face of sudden stops," Journal of Monetary Economics, Elsevier, vol. 59(5), pages 512-527.
    26. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
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