Sovereign Risk Contagion

Cristina Arellano, Yan Bai and Sandra Lizarazo

No 559, Staff Report from Federal Reserve Bank of Minneapolis

Abstract: We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders' pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactual exercise, we find that the debt crisis in Spain (Italy) can account for one-half (one-third) of the increase in the bond spreads of Italy (Spain).

Keywords: Bond spreads; Sovereign default; Renegotiation; European debt crisis (search for similar items in EconPapers)
JEL-codes: F30 G01 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2017-11-13
New Economics Papers: this item is included in nep-dge, nep-eec and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Working Paper: Sovereign Risk Contagion (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:559

DOI: 10.21034/sr.559

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