A Structural Model for Sovereign Credit Risk

This paper provides, and empirically estimates, a structural model of sovereign default risk on external debt. The sovereign endogenously determines its level of foreign debt and default policy. Consistent with default crisis episodes, the sovereign and its lenders bargain at default over a reduction of the debt service. The potential for debt restructuring o¤ers the sovereign greater incentive to default. This model o¤ers theoretical predictions of the relationship between credit spreads and related macro-variables that are consistent with the empirical literature. I also compare estimates of daily credit spreads implied by the structural model with observed EMBI+ spreads for Brazil, Mexico, Peru, and Russia over the period 1998-2006. In a panel analysis, the model explains about 92% of the time variation in daily credit spreads. In contrast to some recent studies, there remains limited scope for additional explanation from U.S. Treasury rates and the VIX index. JEL Codes: F34, G12, G13, G15 Keywords: Sovereign Debt, Debt Renegotiation, Contingent-Claims Model, Credit Risk, Sovereign Spreads, Default Probabilities Acknowledgements: I am deeply grateful to Darrell Du¢ e and Bernard Dumas for insightful discussions and priceless comments. This paper has also greatly bene…ted from suggestions provided by Tim Bollerslev, Ricardo J. Caballero, Jean Imbs, Philippe Jorion, Erwan Morellec, Pascal François, Rajna Gibson, participants of the 2007 Paris Finance International Meeting, the 2008 Financial Risks International Forum on Structured Products and Credit Derivatives, and seminar participants at University of Zurich. I acknowledge the …nancial support from Swiss Finance Institute and the NCCR FINRISK, managed by the Swiss National Science Foundation. All errors, conclusions and opinions contained herein are solely those of the author. yThe author is currently a visiting research fellow at the Kennedy School Harvard University.Permanent contact details : University of Lausanne Ecole des HEC, Extranef (o¢ ce 201), Lausanne, Switzerland. E-mail: [email protected], [email protected]