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Default and the Term Structure in Sovereign Bonds


  • Cristina Arellano

    () (Department of Economics University of Minnesota)

  • Ananth Ramanarayanan


This paper builds a dynamic model of borrowing and default to study the term structure of sovereign bonds in emerging markets. The borrower in the model can buy short and long bonds at contingent prices that reflect the timing of default events. The model generates a yield curve that is upward sloping on tranquil times as in the data. The reason is that if default events are likely in the future but not in the near term, only the long yield will be adjusted for this. However if default is a likely event in the near future the yield curve is inverted. In this case, long bonds are safer than short bonds for lenders in present value terms, because if the economy avoids the stressed period, it may repay its debt obligations in all future states. This matches the data in emerging markets bonds where in times of crises yields of shorter bonds are higher. The model also delivers that long bonds are issued primarily on tranquil times and short debt is used more heavily during crisis as in emerging markets. In the model long debt provides a good hedge against future bad shocks because the effective cost for such borrowing is lower exactly in times of high interest rates. Thus the borrower prefers in tranquil times long bonds because of the additional benefits. In addition, this effect increases borrowing incentives which in equilibrium translates into higher default probabilities. We calibrate the model to Brazil and find that the model can match various features of the data including the volatility of long and short bonds yields.

Suggested Citation

  • Cristina Arellano & Ananth Ramanarayanan, 2006. "Default and the Term Structure in Sovereign Bonds," 2006 Meeting Papers 299, Society for Economic Dynamics.
  • Handle: RePEc:red:sed006:299

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    Cited by:

    1. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2013. "Why Do Emerging Economies Borrow Short Term?," Journal of the European Economic Association, European Economic Association, vol. 11, pages 67-100, January.
    2. Laura Alfaro & Fabio Kanczuk, 2009. "Debt Maturity: Is Long‐Term Debt Optimal?," Review of International Economics, Wiley Blackwell, vol. 17(5), pages 890-905, November.
    3. Richard H. Clarida & Ildikó Magyari, 2016. "International Financial Adjustment in a Canonical Open Economy Growth Model," NBER Working Papers 22758, National Bureau of Economic Research, Inc.
    4. Ran Bi, 2008. ""Beneficial" Delays in Debt Restructuring Negotiations," 2008 Meeting Papers 766, Society for Economic Dynamics.
    5. Arteta, Carlos & Hale, Galina, 2008. "Sovereign debt crises and credit to the private sector," Journal of International Economics, Elsevier, vol. 74(1), pages 53-69, January.
    6. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2009. "Heterogeneous Borrowers In Quantitative Models Of Sovereign Default," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(4), pages 1129-1151, November.
    7. Leonardo Martinez & Juan Carlos Hatchondo, 2008. "A model of credit risk without commitment," 2008 Meeting Papers 940, Society for Economic Dynamics.

    More about this item


    Sovereign Debt; Default; Term Structure;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F31 - International Economics - - International Finance - - - Foreign Exchange


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