Sovereign Default, Risk-Averse Investors and the World Interest Rate

Sammanfattning: Empirical evidence suggests that global factors, such as the world interest rate and the degree of risk-aversion of international investors, are key drivers of sovereign spreads in emerging economies. Building on this evidence, this paper extends a model of strategic sovereign default to account for both a time-varying world interest rate and risk-averse international investors, in order to study the impact of these factors on sovereign debt prices and default incentives. To this end, the proposed model is solved numerically by means of Value and Policy Function Iteration. In order to evaluate the implications of risk-averse investors and fluctuations in the world interest rate, the quantitative predictions of the enriched framework presented in this paper are contrasted with the results obtained in a standard sovereign default model. The main findings of this paper suggest that global risk-aversion indeed plays a crucial role in explaining sovereign spreads, while changes in the world interest rate only have a minor impact.