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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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    File URL: https://www.economicdynamics.org/meetpapers/2012/paper_608.pdf
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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
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    Handle: RePEc:red:sed012:608
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    17. Ananth Ramanarayanan & Cristina Arellano, 2008. "Default and the Maturity Structure in Sovereign Bonds," 2008 Meeting Papers 479, Society for Economic Dynamics.
    18. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    19. 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.
    20. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
    21. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & Jose-Victor Rios-Rull, 2007. "A quantitative theory of unsecured consumer credit with risk of default," Working Papers 07-16, Federal Reserve Bank of Philadelphia.
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    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.
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