The Term Structure of Sovereign Spreads in Emerging Markets

Abstract

A simple structural model to estimate the term structure of sovereign spreads and the implied default probability of a selected group of emerging countries can account for more than 50% of the J.P. Morgan EMBIG index. The real exchange rate dynamics, modeled as a pure diffusion process, are assumed to trigger default events. Relaxing the hypothesis of market completeness, the model generates sovereign spread curves consistent with market data. The robustness of the model indicates a need to reexamine the criticism that structural models underestimate market spreads. The results suggest that the market tends to overprice the spreads for Brazil by 120 basis points on average, but it reproduces the market behavior for Mexico, Russia, and Turkey. These findings are supported by credit rating agency upgrades of the ratings for Brazil in the second half of 2004, just after the study period.