Determinants of Sovereign Risk: Macroeconomic fundamentals and the pricing of sovereign debt

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Determinants of Sovereign Risk: Macroeconomic fundamentals and the pricing of sovereign debt

by Jens Hilscher of Brandeis University, and
Yves Nosbusch of the London School of Economics

July 2008

Abstract: This paper investigates the effects of macroeconomic fundamentals on emerging market sovereign credit spreads. We pay special attention to the volatility of fundamentals in addition to their levels. In reduced form regressions, the volatility of terms of trade in particular has a statistically and economically significant effect on spreads. We propose an empirically tractable model that addresses the distinct features of sovereign risk. Our model captures a significant part of the empirical variation in spreads. It fits better for borrowers of lower credit quality. We also estimate default probabilities in a hazard model and link these probabilities to observed spreads.

JEL Classification: F34, G12, G13, G15.

Keywords: sovereign spreads, credit risk, bond pricing, terms of trade, default probabilities.

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