A Theory of Sovereign Bond Safety: Country Size and Equity Rebalancing

55 Pages Posted: 18 Sep 2023

See all articles by Chang He

Chang He

University of California, Los Angeles (UCLA) - Department of Economics

Xitong Hui

London School of Economics & Political Science (LSE) - Department of Economics

Date Written: September 5, 2023

Abstract

This paper provides a theoretical framework to understand sovereign bond safety in both normal and in crisis times. Using a continuous-time two-country Lucas tree model with equity constraint, we show that the country-size effect and the equity-rebalancing effect are the key determinants of sovereign bond safety. The country size effect spills over home production risk to a smaller country through trade and equity rebalancing; equity constraint limits equity rebalancing and creates endogenous uncovered interest parity (UIP) deviations in both normal and crisis times. In the period of crisis, the larger country’s sovereign bond becomes a global safe asset when the country size effect dominates the equity rebalancing effect, as is the case with the United States. Our model mechanisms qualitatively explain the empirical evidence on the country-size and equity-rebalancing effect for both the G10 and emerging market currencies. Our model predictions also reconcile with the empirical facts of flight-to-safety and the covered interest parity (CIP) in both normal and crisis times.

Keywords: Uncovered interest parity (UIP), safe assets, sovereign bonds, equity rebalancing, continuous-time finance

JEL Classification: F31, F41, G15

Suggested Citation

He, Chang and Hui, Xitong, A Theory of Sovereign Bond Safety: Country Size and Equity Rebalancing (September 5, 2023). Available at SSRN: https://ssrn.com/abstract=4562487 or http://dx.doi.org/10.2139/ssrn.4562487

Chang He (Contact Author)

University of California, Los Angeles (UCLA) - Department of Economics ( email )

8283 Bunche Hall
Los Angeles, CA 90095-1477
United States

Xitong Hui

London School of Economics & Political Science (LSE) - Department of Economics

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