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Interest Rate Uncertainty and Sovereign Default Risk

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  • Alok Johri
  • Shahed Khan
  • César Sosa-Padilla

Abstract

Empirical studies suggest that fluctuations in the level and volatility of the world interest rate affect sovereign spreads in emerging economies. We incorporate an estimated time-varying process for the world interest rate (with both level and volatility shocks) into a model of sovereign default calibrated to a panel of emerging economies. Time variation in the world interest rate interacts with default incentives in the model and leads to state contingent effects similar to the empirical literature. On average, in response to a rise in the world interest rate the model delivers a 1.4 times increase in the spread. The volatility state has a major impact on this average – the increase in spreads is much larger in high volatility states. Moreover, we show that fluctuations in the world interest rate can generate considerable co-movement in sovereign yields across nations, as seen in the data.

Suggested Citation

  • Alok Johri & Shahed Khan & César Sosa-Padilla, 2020. "Interest Rate Uncertainty and Sovereign Default Risk," NBER Working Papers 27639, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:27639
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    Cited by:

    1. Javier Bianchi & Cesar Sosa-Padilla, 2018. "Reserve Accumulation, Macroeconomic Stabilization and Sovereign Risk," 2018 Meeting Papers 1166, Society for Economic Dynamics.
    2. César Sosa-Padilla & Federico Sturzenegger, 2021. "Does It Matter How Central Banks Accumulate Reserves? Evidence from Sovereign Spreads," Working Papers 79, Red Nacional de Investigadores en Economía (RedNIE).
    3. Reyes-Heroles, Ricardo & Tenorio, Gabriel, 2019. "Regime-switching in emerging market business cycles: Interest rate volatility and sudden stops," Journal of International Money and Finance, Elsevier, vol. 93(C), pages 81-100.
    4. de Ferra, Sergio & Mallucci, Enrico, 2022. "Sovereign risk matters: Endogenous default risk and the time-varying volatility of interest rate spreads," Journal of International Economics, Elsevier, vol. 134(C).
    5. Alok Johri & Johnny Cotoc, 2021. "The Bribe Rate and Long Run Differences in Sovereign Borrowing Costs," Department of Economics Working Papers 2021-02, McMaster University.

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    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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