Interest Rate Uncertainty and Sovereign Default Risk

Abstract

Fluctuations in sovereign bond yields display a large global component which is associated with a rise in uncertainty. We build a model of sovereign default in which shocks to the level and to the volatility of the world interest rate help to account for this phenomenon. We calibrate the model parameters to Argentine data and estimate a process for the world interest rate using US treasuries data. Time variation in the world interest rate interacts with default incentives and its effect on borrowing and sovereign spreads is state contingent. We find that shocks to the level and volatility of the world interest rate (i.e. uncertainty shocks) cause the model to predict an average sovereign spread that is 280 basis points larger and 200 basis points more volatile than a model with a constant world interest rate. The model also predicts that countries will prefer a longer maturity for their debt when facing a time-varying world interest rate. The welfare gains from eliminating uncertainty about the world interest rate amount up to a permanent increase in consumption of 1 percent.