News and Sovereign Default Risk in Small Open Economies

29 Pages Posted: 26 Jun 2010

See all articles by Ceyhun Bora Durdu

Ceyhun Bora Durdu

Board of Governors of the Federal Reserve System

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston

Horacio Sapriza

Board of Governors of the Federal Reserve System

Date Written: May 28, 2010

Abstract

This paper builds a model of sovereign debt in which default risk, interest rates, and debt depend not only on current fundamentals but also on news about future fundamentals. News shocks affect equilibrium outcomes because they contain information about the future ability of the government to repay its debt. First, in the model with news shocks not all defaults occur in bad times, bringing the model closer to the data. Second, the news shocks help account for key differences between emerging markets and developed economies: as the precision of the news improves the model predicts lower variability of consumption, less countercyclical trade balance and interest rate spreads, as well as a higher level of debt more in line with the characteristics of developed economies. Finally, the model also captures the hump-shaped relationship between default rates and the precision of news obtained from the data.

Keywords: Sovereign default risk, news shocks, endogenous borrowing constraints

JEL Classification: F34, F41

Suggested Citation

Durdu, Ceyhun Bora and Nunes, Ricardo Cavaco and Sapriza, Horacio, News and Sovereign Default Risk in Small Open Economies (May 28, 2010). FRB International Finance Discussion Paper No. 997, Available at SSRN: https://ssrn.com/abstract=1629247 or http://dx.doi.org/10.2139/ssrn.1629247

Ceyhun Bora Durdu (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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HOME PAGE: http://www.ceyhunbora.com

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

Horacio Sapriza

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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