Ebook Determinants of Sovereign Risk
At an empirical level, there is tremendous variation in the cost of external borrowing faced by emerging market economies. This is true both across countries and over time. A common measure of this cost is a country’s yield spread, which is defined as the difference between the interest rate the government has to offer on its external U.S. dollar denominated debt and the rate paid by the U.S. Treasury on debt of comparable maturity.
From the perspective of emerging market sovereign borrowers, it is important to understand what drives these differences in borrowing costs, given the central role external debt plays in the public finances of many of these countries. International investors also need to know the underlying factors determining yield spreads in order to decide if they are adequately compensated for the risk they are taking.
We investigate how much of the variation in sovereign yield spreads can be explained by fundamental factors in the context of a structural model of debt prices. Standard structural models of risky corporate debt pricing cannot be used when pricing sovereign debt. In these models, the firm defaults and is taken over by creditors if firm asset value falls below liabilities. Risky debt is priced as a combination of safe debt and a short position in a put option. In the sovereign case, there is no equivalent of firm asset value with an observable market price. Moreover, even if one could agree on an underlying wealth measure, creditors typically do not hold claims to a country’s assets in the event of default. As a result, it is a priori unclear what a country’s default threshold would be in terms of such a wealth measure.
We propose a model that addresses the distinct features of the sovereign debt market while retaining the familiar intuition of structural bond pricing models. In our model an index of macroeconomic fundamentals determines default and recovery value. Intuitively, once fundamentals fall below a certain threshold, the cost of repayment becomes too high and the country goes into default. As in standard bond and option pricing models, a higher volatility of the index implies a higher probability of default, a higher value of the put option, and therefore a higher spread.
There are two main parts to the empirical analysis of the paper. We first explore the empirical determinants of spreads and default probabilities in a reduced form framework. As motivated by our model, we focus in particular on the role of volatility. We then fit the model to price bonds directly. We use spread observations on external U.S. dollar denominated debt from J.P. Morgan’s Emerging Market Bond Index (EMBI). Spreads are calculated over U.S. Treasuries of comparable maturity and cover a set of 32 emerging market countries from 1994 to 2002.
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