The Dynamics of Sovereign Credit Risk

Abstract

This paper proposes a structural model for sovereign credit risk with endogenous sovereign debt and default policies. A maximum-likelihood estimation of the model with local stock market prices generates daily model-implied sovereign spreads. This approach explains two-thirds of the daily variation in observed sovereign spreads for emerging and European economies over the 2000-2011 period. Global factors help to further explain the time variation in sovereign credit risk. In particular, sovereign spreads in emerging markets vary with U.S. market uncertainty, while European spreads depend on Euro zone bond factors.

Keywords: Sovereign Debt, Credit Risk, Asset Pricing, International Financial Markets

JEL Classification: F34, G12, G13, G15