Sovereign Risk and Financial Risk

Abstract

This paper examines the relationship between sovereign bond spreads, local economic activity, and global financial risk. We use secondary-market prices of dollar-denominated sovereign securities to construct yield spreads between sovereign bond yields and yields on the appropriately defined default risk-free securities, constructed using zero-coupon U.S. Treasury yields. We use these spreads to construct country-specific sovereign bond spreads for a sample of almost 50 countries over the 1980-2012 period. We then examine the extent to which movements in sovereign spreads are determined by local risk factors, such as fluctuations in exchange rates and local stock market returns, versus global risk factors that arguably proxy for risk-attitudes that prevail in U.S. financial markets. To measure global risk factors we rely on the excess bond premium constructed by Gilchrist and Zakrajsek (2012). The excess bond premium is a measure of distress in U.S. corporate bond markets and comoves closely with conditions in financial markets. According to GZ, the excess bond premium provides a quantitative measure of the risk-attitudes of financial intermediaries. Our results indicate that a substantial portion of the comovement among sovereign spreads can be accounted for by changes in such global risk factors. We also examine the extent to which, during the 2007-09 financial crisis, such global risk factors were related to perceived default risk in the U.S. financial sector. Next, we extend our methodology to construct credit spreads for euro-denominated sovereign bonds for about 40 countries over the 2000-2012 period, and we examine the implications of our empirical pricing framework for comovement among sovereign spreads during the ongoing turmoil in European sovereign debt markets. Lastly, we study the e§ect of various stabilization policy announcements during the recent financial crisis on sovereign bond spreads through the global risk factors. We also compare the impacts of stabilization policy measures during financial crises in the past. Lastly, we construct a general equilibrium model of sovereign debt and default to rationalize the empirical findings. The model features include a risk-averse global investor, optimal default, and endogenous debt dynamics for multiple countries. The sovereign default and bond prices depend on the borrower's economic conditions as well as the lender's risk aversion and riskiness. We quantitatively examine the link between the financial risk that the lender faces and the distribution of sovereign risk.