Sovereign Default, Exchange Rates, and International Asset Prices

This article develops a framework that combines the economics behind the structural modeling of sovereign credit risk, corporate capital structure, and the equilibrium modeling of international asset pricing. The default decisions of the sovereign and the firm are derived optimally and embedded in a two-country, two-good consumption-based asset-pricing model with a representative risk-averse agent for each country. The foreign exchange market acts as the main channel through which shocks are transmitted internationally. This framework can explain (i) the first two moments of international equity returns; (ii) the co-movement across returns on equity, corporate debt, and sovereign debt, in addition to co-movement in international equity return volatilities; and (iii) the negative relationship between equity return volatility in developed economies and sovereign credit risk in emerging economies. A structural test using the general methods of moments provides strong support for the model. In particular, the risk of a sovereign default crisis is highly relevant in the explanation of the dynamics of international equity returns. JEL Codes: F31, F34, G12, G13, G15