Sovereign Risk Premia
73 Pages Posted: 13 Oct 2011
Date Written: May 13, 2011
Emerging countries tend to default when their economic conditions worsen. If bad times in an emerging country correspond to bad times for the US investor, then foreign sovereign bonds are particularly risky. We explore how this mechanism plays out in the data and in a general equilibrium model of optimal borrowing and default. Empirically, the higher the correlation between past foreign and US bond returns, the higher the average sovereign excess returns. In the model, sovereign defaults and bond prices depend not only on the borrowers' economic conditions, but also on the lenders' time-varying risk-aversion.
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