Determinants of Sovereign Risk: Macroeconomic Fundamentals and the Pricing of Sovereign Debt

Standard option pricing theory cannot be applied when pricing sovereign debt. In the case of a country, there is no underlying asset that is traded or to which creditors hold claims in the event of default. We propose an empirically tractable model that addresses the distinct features of sovereign risk while retaining the intuition of the standard option pricing framework. In our model, an index of macroeconomic variables drives yield spreads over U.S. Treasuries, the probability of default, and the recovery value conditional on default. Our model predicts that both the level and the volatility of fundamentals matter for default risk. Using data on external sovereign debt prices for a sample of emerging market countries, we find that the volatility of terms of trade has a statistically and economically significant effect on spreads and default probabilities. The ratio of debt to GDP explains variation mainly in the time series of spreads rather than in the cross section. A variable summarizing a country's recent default history has additional explanatory power. Fitting our model to the data, we find that it can account for close to one third of observed spread variation. A one percent increase in the model predicted spread is associated with a 0.73 percent increase in the realized spread. We also find that the model fits better for borrowers of lower credit quality, a result that is consistent with recent findings in the corporate bond literature