The Dynamics of Sovereign Credit Risk
by Alexandre Jeanneret of the University of Lausanne & Swiss Finance Institute
August 4, 2009
Abstract: This paper provides a model for sovereign default risk valuation in which a sovereign country endogenously determines the timing of default on its external debt. The theoretical relationships between credit spreads and the macroeconomic factors considered in the model are consistent with the empirical literature. The model explains the variation across time in daily Emerging Market Bond Index (EMBI+) spreads to a degree not offered by existing theoretical and empirical models. I use price data information on stock market indices to compute credit spreads for Brazil, Mexico, Peru, and Russia over 1998-2008. The out-of-sample analysis focuses on the subprime crisis period from January 1, 2007, through December 31, 2008. The model explains 32% of the out-of-sample time variation in EMBI+ spread changes. The enhanced explanatory power of the model is due to a transformation of the non-linear relationship between observed EMBI+ spreads and daily stock market prices into a linear relationship between model spreads and EMBI+ spreads. The inclusion of additional variables (namely, the VIX, S&P 500 return, and U.S. Treasury rate) raises the explanatory power to 45%. I also show that accounting for a time-varying sovereign incentive to default can best explain the level of EMBI+ spreads, especially during the recent period of distress.
Keywords: Sovereign Debt, Credit Risk, Sovereign Spreads, Debt Renegotiation.