Sovereign Default Risk and the US Equity Market

Abstract:     
I build an international structural model with defaultable firms and governments that demonstrates how European sovereign default risk affects the US equity market. Investors view the risk of a sovereign debt crisis as the risk of a long-term economic slowdown in Europe that transmits to the US through the exchange rate. Such risk reduces the value of equity and increases the level of volatility. The sensitivity to sovereign default risk is predicted to be strongest in adverse economic conditions, when firms are close to financial distress. This countercyclicality plays a key role in the valuation of firm assets and helps explain the levels and the dynamics of equity volatility in Europe and the US. A structural estimation with European and US macroeconomic data over 1990-2011 provides strong support for the model.

Number of Pages in PDF File: 50

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

JEL Classification: F31, F34, G12, G13, G15

working papers series