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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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    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
    Date of revision:
    Handle: RePEc:fip:fedbwp:12-11
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    1. Ananth Ramanarayanan & Cristina Arellano, 2008. "Default and the Maturity Structure in Sovereign Bonds," 2008 Meeting Papers 479, Society for Economic Dynamics.
    2. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
    3. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
    4. 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.
    5. Juan Carlos Hatchondo & Leonardo Martinez, 2012. "Debt dilution and sovereign default risk," Working Paper 10-08, Federal Reserve Bank of Richmond.
    6. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
    7. Mark Aguiar & Gita Gopinath, 2007. "Emerging Market Business Cycles: The Cycle Is the Trend," Journal of Political Economy, University of Chicago Press, vol. 115, pages 69-102.
    8. 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.
    9. Juan Escobar & Ulrich Doraszelski, 2008. "A Theory of Regular Markov Perfect Equilibria\\in Dynamic Stochastic Games: Genericity, Stability, and Purification," 2008 Meeting Papers 453, Society for Economic Dynamics.
    10. Martin Uribe & Vivian Z. Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    11. Young, Eric R., 2012. "Robust policymaking in the face of sudden stops," Journal of Monetary Economics, Elsevier, vol. 59(5), pages 512-527.
    12. 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.
    13. 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.
    14. David Benjamin, 2008. "Recovery Before Redemption," 2008 Meeting Papers 531, Society for Economic Dynamics.
    15. Yue, Vivian Z., 2010. "Sovereign default and debt renegotiation," Journal of International Economics, Elsevier, vol. 80(2), pages 176-187, March.
    16. 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.
    17. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    18. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Macroeconomic Risk," American Economic Review, American Economic Association, vol. 97(2), pages 1-30, May.
    19. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Economic Risk," NBER Working Papers 12948, National Bureau of Economic Research, Inc.
    20. Arellano, Cristina, 2008. "Default risk and income fluctuations in emerging economies," MPRA Paper 7867, University Library of Munich, Germany.
    21. Lizarazo, Sandra, 2010. "Default Risk and Risk Averse International Investors," MPRA Paper 20794, University Library of Munich, Germany.
    22. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Online Appendix to "Quantitative properties of sovereign default models: solution methods"," Technical Appendices 08-133, Review of Economic Dynamics.
    23. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
    24. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
    25. repec:oup:restud:v:48:y:1981:i:2:p:289-309 is not listed on IDEAS
    26. Barro, Robert, 2006. "Rare Disasters and Asset Markets in the Twentieth Century," Scholarly Articles 3208215, Harvard University Department of Economics.
    27. Pascal J. Maenhout, 2004. "Robust Portfolio Rules and Asset Pricing," Review of Financial Studies, Society for Financial Studies, vol. 17(4), pages 951-983.
    28. 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.
    29. 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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