Mispricing of Risk in Sovereign Bond Markets with Asymmetric Information

Mihm Benedikt
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Mihm Benedikt: Otto-von-Guericke University Magdeburg, Universitätspl. 2,Magdeburg, Germany

German Economic Review, 2016, vol. 17, issue 4, 491-511

Abstract: The likelihood that a government will repay its sovereign debt depends both on the amount of debt it issues and on the government’s future ability to repay. Whilst the former is publicly observable, the government may have more information about the latter than investors. This paper shows that this asymmetric information problem impairs the market’s ability to differentiate economies according to their fiscal sustainability, and can lead to a disconnect between bond prices and default risk. The model can help rationalise the behaviour of Eurozone bond prices prior to the recent European sovereign debt crisis.

Keywords: Default risk; sovereign debt; political uncertainty; signalling (search for similar items in EconPapers)
Date: 2016
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DOI: 10.1111/geer.12068

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