Sovereign risk matters: Endogenous default risk and the time-varying volatility of interest rate spreads

Sergio de Ferra and Enrico Mallucci

Journal of International Economics, 2022, vol. 134, issue C

Abstract: Emerging markets’ interest rate spreads display substantial time-varying volatility. We show that models with endogenous sovereign default risk à la Eaton and Gersovitz (1981) can account for such volatility, even in the absence of shocks to the second moments of the exogenous stochastic variables. In particular, these models feature a key non-linearity that allows them to replicate the stochastic volatility of interest rate spreads and its comovement with other important economic variables. Volatility correlates positively with the level of the spreads and the trade balance, negatively with output and consumption. Hence, sovereign default models endogenize the stochastic volatility of interest rates observed in emerging market economies.

Keywords: Sovereign risk; time-varying volatility; interest rate spreads (search for similar items in EconPapers)
JEL-codes: E32 E43 F32 F34 (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:134:y:2022:i:c:s0022199621001227

DOI: 10.1016/j.jinteco.2021.103542

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