Strategic And Insolvency Risk In Sovereign Debt Pricing: An Experimental Study

After the 2007 Global Financial Crisis, tensions in sovereign bond markets of advanced economies occurred quite frequently, driven by a combination of deteriorating fundamentals and self-fulfilling beliefs. However, it is difficult to disentangle empirically the contribution of these two factors in explaining government bond yields during episodes of sovereign debt distress. In this paper, we address this challenge through a controlled laboratory experiment. In the experiment, a government issues one-period bonds through a discriminatory price auction to finance a legacy of government debt. In a baseline treatment, sovereign default can result from investors' failure to coordinate in purchasing bonds (strategic risk) or the government debt reaching a solvency limit (fundamental risk). In a second treatment, a central bank intervenes as a bondholder-of-last-resort and eliminates roll-over defaults. We find that investors correctly price the probability of government default and demand higher interest rates as the risk of default increases. At the same time, the required risk premium is lower in the treatment with a central bank compared to the baseline treatment. The difference between interest rates across the two treatments can be viewed as the illiquidity component of sovereign debt risk.