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Sovereign Default Risk and Uncertainty Premia

  • Ignacio Presno

    (Federal Reserve Bank of Boston)

  • Demian Pouzo

    (UC at Berkeley)

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    This paper develops a general equilibrium model of sovereign debt with endogenous default. Foreign lenders fear that the probability model which dictates the evolution of the endowment of the borrower is misspecied. To compensate for the risk and uncertainty-adjusted probability of default, they demand higher returns on their bond holdings. In contrast with the existing literature on sovereign default, we are able to match the average bond spreads observed in the data together with the standard empirical regularities of emerging economies. The technical contribution of the paper lies in extending the methodology of McFadden (1981) to compute equilibrium allocations and prices using the discrete state space (DSS) technique in the context of risk and uncertainty aversion on the lenders' side.

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    Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 608.

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    Date of creation: 2012
    Date of revision:
    Handle: RePEc:red:sed012:608
    Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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    8. Martin Uribe & Vivian Z. Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
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    18. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
    19. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    20. Timothy J Kehoe & David K Levine, 1993. "Debt Constrained Asset Markets," Levine's Working Paper Archive 1276, David K. Levine.
    21. Barillas, Francisco & Hansen, Lars Peter & Sargent, Thomas J., 2009. "Doubts or variability?," Journal of Economic Theory, Elsevier, vol. 144(6), pages 2388-2418, November.
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    23. Adrien Verdelhan & Nicola Borri, 2010. "Sovereign Risk Premia," 2010 Meeting Papers 1122, Society for Economic Dynamics.
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