Sovereign Risk Contagion
Yan Bai and
Sandra Lizarazo ()
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Cristina Arellano: Federal Reserve Bank of Minneapolis
Yan Bai: University of Rochester
No 559, Staff Report from Federal Reserve Bank of Minneapolis
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: Sovereign default; Bond spreads; Renegotiation; European debt crisis (search for similar items in EconPapers)
JEL-codes: F30 G01 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-eec and nep-opm
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Working Paper: Sovereign Risk Contagion (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:559
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