Sovereign Default Risk and Uncertainty Premia

TL;DR

This paper explores how fears of model misspecification among international investors influence sovereign bond spreads, introducing a model that aligns with observed data and maintains realistic default frequencies.

Contribution

It develops a novel equilibrium model incorporating investor concerns about model misspecification, explaining bond spreads and default behavior more accurately.

Findings

Model matches Argentina's bond spread dynamics

Higher spreads due to uncertainty premiums

Default frequency remains historically low

Abstract

This paper studies how international 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 match the bond spreads dynamics observed in the data together with other business cycle features for Argentina, while preserving the default frequency at historical low levels.