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Sovereign Risk Premia

by Nicola Borri of Boston University, and
Adrien Verdelhan of Boston University

December 1, 2008

Abstract: Emerging countries tend to default when their economic conditions worsen. If bad times in an emerging country correspond to bad times for the US investor, then these foreign sovereign bonds are particularly risky and should offer high returns. We explore how this mechanism plays out in the data and in a general equilibrium model of optimal borrowing and default. Empirically, we obtain a cross-section of sovereign bond returns: the higher the correlation between past bond returns and US corporate default risk, the higher the average bond returns. A model of risk-averse lenders with external habit preferences can replicate this feature.

JEL Classification: G12, G15, F34, F21.

Keywords: Emerging Markets, Time-varying risk premium, Habit.

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