Sovereign Credit Risk with Endogenous Default

This paper provides a model of sovereign default risk pricing, in which a sovereign country endogenously determines the timing of default on its external debt. The theoretical relationships between credit risk and the macro-variables considered in the model are consistent with the empirical literature. The model also helps to explain the variation across time in Emerging Market Bond Index (EMBI+) spreads to a degree not o¤ered by prior theoretical or empirical models. The model credit spreads explain 77% of the time variation in quarterly credit spreads for Brazil, Mexico, Peru, and Russia over the period 1998-2006, using quarterly data on government revenue. Accounting for daily information on stock market prices, the explanatory power rises to 92%. The success of the model lies in the transformation of the non-linear relationship between observed EMBI+ spreads and quarterly government revenue, or daily stock market prices, into a linear relationship between the model spreads and EMBI+ spreads. I also show that endogenizing the recovery rate upon default helps to better capture the high level of EMBI+ spreads. JEL Codes: F34, G12, G13, G15 Keywords: Sovereign Debt, Credit Risk, Sovereign Spreads, Debt Renegotiation Acknowledgements: I am deeply grateful to Darrell Du¢ e and Bernard Dumas for insightful discussions and priceless comments. This paper has also greatly bene…ted from suggestions provided by Laura Alfaro, Daniel Andrei, Tim Bollerslev, Ricardo J. Caballero, John Y. Campbell, Je¤rey A. Frankel, Ricardo Hausmann, Michael Hutchison, Jean Imbs, Philippe Jorion, Robert C. Merton, Erwan Morellec, Pascal François, Rajna Gibson, Roberto Rigobon, René Stulz, Michael Waibel, Vivian Yue, participants of the 2007 Paris Finance International Meeting, the 2008 Derivatives Securities and Risk Management FDIC Conference, the 2008 Swiss Doctoral Workshop in Finance, the 2008 European Finance Association, and seminar participants at Harvard University, UC Santa Cruz, University of Lausanne, and University of Zurich. I acknowledge the …nancial support from Swiss Finance Institute and the NCCR FINRISK, managed by the Swiss National Science Foundation. An earlier version of this article has circulated as "A Structural Model for Sovereign Credit Risk". This research has been completed while the author was a visiting research fellow at Harvard University. All errors, conclusions and opinions contained herein are solely those of the author. yThe author is currently a visiting scholar at UCLA Anderson School of Management. Permanent contact details: University of Lausanne, Institute of Banking and Finance, Extranef 201, 1015 Lausanne, Switzerland [email protected]