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A Structural Model for Sovereign Credit Risk

This paper provides a structural model, and an accompanying empirical analysis, of sovereign default risk. The model help explain the variation across time in EMBI+ spreads to a degree that had not been offered by prior empirical models. I also generate theoretical predictions of the relationship between credit risk and the macro-variables provided by the model that are consistent with the empirical literature. Sovereign foreign debt has been at the center of a number of international lending crises and now constitutes the largest asset class in emerging markets, representing approximately $5,500bn of principal in 2007 (FT, 2007).

I generate estimates of daily credit spreads implied by the structural model for Brazil, Mexico, Peru, and Russia over the period 1998-2006, and compare these estimates with observed EMBI+ spreads. I use each country's stock market index as the only time-varying explanatory variable. In a panel analysis with fi?xed effects, the credit spreads predicted by the model explain about 92% of the variation across time in daily EMBI+ spreads.

The explanatory power rises only slightly, to 94%, when accounting for additional time-varying factors such as 5-year U.S. Treasury rates and the VIX option implied volatility index. This ?nding may change one's interpretation of the results of Longstaff, Pan, Pedersen, and Singleton (2007) and Pan and Singleton (2008). These authors show that the VIX index is a key factor in explaining credit risk movements, but do not include the factors that I show to almost eliminate VIX as an additional explanatory variable.

This paper offers the first structural model that explains the dynamics of EMBI+ spreads. Prior studies have considered a reduced-form affine structure model, a reduced-form contingent-claims analysis, and a panel-based approach. An advantage of the proposed structural model is that it provides an intuitive theoretical framework for the determinants of credit spreads that can then be used to motivate empirical specifi?cations, such as those of this paper.

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A Structural Model for Sovereign Credit Risk