The Dynamics of Sovereign Credit Risk

Abstract:     
This paper proposes a structural model for sovereign credit risk with endogenous sovereign debt and default policies. The model generates daily sovereign credit spreads using forward-looking information on income taxes structurally extracted from the local stock market. The model-implied spreads explain over half of the daily variation in sovereign spreads for emerging and European economies over the 2000-2011 period. Furthermore, this paper shows that the links between sovereign credit risk and previously considered global factors greatly differ across countries. In particular, emerging spreads exhibit high sensitivity to global market uncertainty, whereas European spreads rather depend on global funding liquidity in the Euro zone. Results are robust in- and out-of-sample, and hold before and during the European debt crisis.

Number of Pages in PDF File: 50

Keywords: Sovereign Debt, Credit Risk, Asset Pricing, International Financial Markets

JEL Classification: F34, G12, G13, G15

working papers series