Sovereign Credit Risk and Real Economic Shocks

Abstract:     
This paper develops a general equilibrium model for credit default swaps where both the price of risk and the default process are driven by global expected consumption growth and macroeconomic uncertainty. The model quantitatively reproduces (i) the unconditional mean and (ii) volatility of the term structure, (iii) the skewness and (iv) persistence of the credit spreads, (v) the decreasing pattern of the kurtosis with asset maturity as well as (vi) historically observed cumulative default probabilities. In addition, (vii) for an investor who is sensitive to downside risk, the model conditionally matches the magnitude of the slope reversal for distressed sovereign borrowers in states of bad macroeconomic fundamentals. These findings confirm the existence of time-varying risk premia in the sovereign CDS market as a compensation for exposure to (common) U.S. business cycle risk. Empirically, we show that (viii) expected consumption growth and volatility in the United States explain 75% of the first two principal components, which account for 91% of the variation in daily prices, and (ix) a similar fraction of the level, slope and curvature of the CDS term structure. Our model (x) provides a joint framework for pricing stocks and CDS, in line with existing results on information flow between the two markets.

Number of Pages in PDF File: 61

Keywords: Credit Default Swap Spreads, Default Risk, Equilibrium Asset Pricing, Generalized Disappointment aversion, Markov Chain, Sovereign Debt, Term structure

JEL Classification: C1, C5, C68, G12, G13, G15, F34

working papers series