Time-varying volatility, default and the sovereign risk premium

This paper studies how changes in the volatility of aggregate income affect sovereign spreads. I document a positive correlation between sovereign spreads and aggregate income volatility for a set of European economies. Then, I propose an endogenous sovereign spread model with time-varying volatility to understand this fact. Volatility changes affect savings and the sovereign spread. However, the impact of volatility shocks is state dependent, when the economy is relatively rich an increase in volatility is prone to generate precautionary savings. Instead, when the economy is relatively poor, an increase in volatility is likely to induce an increase in foreign debt and a higher spread. This mechanism is absent in standard business cycle models and only appears because of the default option. Moreover, this mechanism can generate a substantial variability of spreads only due to volatility shocks. In this way, the model is able to rationalize the positive correlation between sovereign spreads and volatility observed in the data.