Loss Aversion and Search for Yield in Emerging Markets Sovereign Debt

Ricardo Sabbadini

No 500, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: Empirical evidence indicates that a decline in international risk-free interest rates decreases emerging markets (EM) sovereign spreads. A standard quantitative model of sovereign default, calibrated to match average levels of debt and spread, does not replicate this feature even if the risk aversion of lenders moves with international interest rates. In this paper, I show that a model with lenders that are loss-averse and have reference dependence, traits suggested by the behavioral finance literature, replicates the noticed stylized fact. In this framework, when international interest rates fall, EM sovereign spreads decline despite increases in debt and default risk. This happens because investors search for yield in risky EM bonds when the risk-free rate is lower than their return of reference. I find that larger spread reductions occur for i) riskier countries; ii) greater declines in the risk-free rate; and iii) higher degrees of loss aversion.

Date: 2019-09
New Economics Papers: this item is included in nep-opm, nep-rmg and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.bcb.gov.br/content/publicacoes/WorkingPaperSeries/wps500.pdf (application/pdf)

Related works:
Working Paper: Loss Aversion and Search for Yield in Emerging Markets Sovereign Debt (2018)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bcb:wpaper:500

Access Statistics for this paper

More papers in Working Papers Series from Central Bank of Brazil, Research Department
Bibliographic data for series maintained by Rodrigo Barbone Gonzalez ().