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Indeterminacy in Sovereign Debt Markets: An Empirical Investigation

Author

Listed:
  • Alessandro Dovis

    (Pennsylvania State University)

  • Luigi Bocola

    (Northwestern University and FRB of Minneapolis)

Abstract

How important was non-fundamental risk in driving interest rate spreads during the euro-area sovereign debt crisis? To answer this question, we consider a quantitative model of sovereign borrowing with three key ingredients: multiple debt maturities, risk averse lenders and coordination failures a la Cole and Kehoe (2000). In this environment, lenders' expectations of a default can be self-fulfilling, and market sentiments contribute to variation in interest rate spreads along with economic fundamentals. We show that the joint distribution of interest rate spreads and debt duration provides information to distinguish between these two sources of default risk. We make use of this result by calibrating the model to match the empirical distribution of Italian sovereign spreads and debt duration. The process for the lenders' stochastic discount factor, a key input in our analysis, is disciplined using moments from the yield curve on safe assets and the euro-area stock price-consumption ratio. Our preliminary results indicate that the rise in Italian interest rate spreads over the 2011-2012 period was mostly the result of bad economic fundamentals and high risk premia, with a limited role played by non-fundamental uncertainty. We show how this information can be used to understand the implications of the OMT program announced by the ECB.

Suggested Citation

  • Alessandro Dovis & Luigi Bocola, 2015. "Indeterminacy in Sovereign Debt Markets: An Empirical Investigation," 2015 Meeting Papers 694, Society for Economic Dynamics.
  • Handle: RePEc:red:sed015:694
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    References listed on IDEAS

    as
    1. Adrien Verdelhan & Nicola Borri, 2010. "Sovereign Risk Premia," 2010 Meeting Papers 1122, Society for Economic Dynamics.
    2. repec:eee:jetheo:v:175:y:2018:i:c:p:803-812 is not listed on IDEAS
    3. Michele Lenza, 2015. "The financial and macroeconomic effects of OMT announcements," Research Bulletin, European Central Bank, vol. 22, pages 12-16.
    4. Lizarazo, Sandra Valentina, 2013. "Default risk and risk averse international investors," Journal of International Economics, Elsevier, vol. 89(2), pages 317-330.
    5. S Borağan Aruoba & Pablo Cuba-Borda & Frank Schorfheide, 2018. "Macroeconomic Dynamics Near the ZLB: A Tale of Two Countries," Review of Economic Studies, Oxford University Press, vol. 85(1), pages 87-118.
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    8. Ayres, João & Navarro, Gaston & Nicolini, Juan Pablo & Teles, Pedro, 2018. "Sovereign default: The role of expectations," Journal of Economic Theory, Elsevier, vol. 175(C), pages 803-812.
    9. Manuel Amador & Mark Aguiar, 2014. "Take the Short Route: How to repay and restructure sovereign debt with multiple maturities," 2014 Meeting Papers 165, Society for Economic Dynamics.
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    12. Harold L. Cole & Timothy J. Kehoe, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Oxford University Press, vol. 67(1), pages 91-116.
    13. Giancarlo Corsetti & Luca Dedola, 2016. "The Mystery of the Printing Press: Monetary Policy and Self-Fulfilling Debt Crises," Journal of the European Economic Association, European Economic Association, vol. 14(6), pages 1329-1371.
    14. Luigi Bocola, 2016. "The Pass-Through of Sovereign Risk," Journal of Political Economy, University of Chicago Press, vol. 124(4), pages 879-926.
    15. Giancarlo Corsetti & Luca Dedola, 2012. "The "Mystery of the Printing Press" Monetary Policy and Self-fulfilling Debt Crises," Discussion Papers 1424, Centre for Macroeconomics (CFM), revised Aug 2014.
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    17. Stangebye, Zachary, 2015. "Dynamic Panics: Theory and Application to the Eurozone," MPRA Paper 69967, University Library of Munich, Germany.
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