Sovereign Default Risk and Uncertainty Premia

Working Paper No. 12-11
by Demian Pouzo and Ignacio Presno
2012 Series

This paper studies how foreign investors' concerns about model misspecification affect sovereign bond spreads. We develop a general equilibrium model of sovereign debt with endogenous default wherein investors fear that the probability model of the underlying state of the borrowing economy is misspecified. Consequently, investors demand higher returns on their bond holdings to compensate for the default risk in the context of uncertainty. In contrast with the existing literature on sovereign default, we explain the bond spreads dynamics observed in the data as well as other business cycle features for Argentina, while preserving the default frequency at historical low levels.

Keywords: sovereign debt, default risk, model uncertainty, robust control

JEL Classifications: D81, E21, E32, E43, E34

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