What Do Sovereign Spreads Say About Expected Defaults and Devaluations? An Application to the European Sovereign Debt Crisis

Abstract

This article outlines two general approaches to disentangle expected defaults and anticipated devaluations from distressed sovereign spreads. The first uses affine term structure models and uncovered interest rate parity to extract a schedule between risk-neutral devaluation odds and exchange rates across the term structure. The second is a discounted expected value model that produces simultaneous estimates of risk-neutral default and devaluation odds, as well as recovery and exchange rates. When applied to the European sovereign debt crisis, both methods suggest that investors’ conviction about the longevity of the European Monetary Union unmoored in mid-2010 and subsequently persisted. This currency dimension poses investment and policy implications that are distinct from, and perhaps much more ominous than, those that stem from default concerns alone.