Sovereign Risk

Adrien Verdelhan
MIT Sloan

April 2013

Road Map for Today

Optimal Sovereign Debt and Default Workhorse Model Benchmark Empirical Spreads

Sovereign Risk Premia Portfolios of EMBI Excess Returns Cross-sectional Asset Pricing Model

Literature

Empirical studies of sovereign bonds and CDS: Acharya, Drechsler, and

Schnabl (2012), Ang and Longsta (2011), Broner, Lorenzoni, and Schmukler (2011), Longsta, Pan, Pedersen and Singleton (2011), Pan and Singleton (2008), Fostel and Geanakoplos (2008), Gonzales-Rozada and Yeyati (2008), Hilscher and Nosbusch (2008), Bekaert, Harvey and Lundblad (2007), Weigle and Gemmill (2006), Benczur and Ilut (2006), Bernoth, von Hagen and Schuknecht (2004), Adler and Qi (2003), McGuire and Schrijvers (2003), Ferrucci (2003), Arora and Cerisola (2001), Westphalen (2001), Kamin and von Kleist (1999), Edwards (1984), Eichengreen and Mody (1998).

Models of sovereign borrowing: Arellano and Ramanarayanan (2012), Acharya

and Rajan (2011), Jeanneret (2010), Broner and Ventura (2010), Andrade (2009), Hatchondo and Martinez (2009), Pouzo (2009), Arellano (2008), Amador (2008), Guerrieri and Kondor (2008), Bolton and Jeanne (2008), Mendoza and Yue (2008), Lizarazo (2008), Broner (2008), Pan and Singleton (2008), Aguiar and Gopinath (2006), Yue (2005), Due, Pedersen, and Singleton (2003), Amador (2003), Alvarez and Jermann (2000), Cole and Kehoe (2000), Kocherlakota (1996), Zame (1993), Kehoe and Levine (1993), Atkeson (1991), Bulow and Rogo (1989), Eaton and Gersovitz (1981).

The Workhorse Model: Eaton and Gersovitz (1981)

Recent version in, for example, Arellano (2008), Aguiar and Gopinath (2006), Arellano and Ramanarayanan (2012) Timing of events in period t :
1 2 3

household receives stochastic endowment YtB ,

t government repays outstanding debt Bt 1 or defaults, if government repays:
t +1 it borrows Bt at the price Qt , it makes a lump-sum good transfer to the household.

if government defaults:
it is excluded from international capital markets for a stochastic number of periods, faces a direct output cost YtB ,def .

Endowment: borrowers
Arellano (2008): Yti = e zt Aguiar and Gopinath (2007): Two components: Yti = e zt it
i, a transitory component zt
i i

a time-varying mean (or permanent component) i t.

zti it gti
g ,i

= z (1 z ) + z zti 1 + = Gti it 1 ,

z ,i t g ,i t .

= log (Gti ) = g (1 g ) + g gti 1 +

are i .i .d normal, E (
g ,i z ,i )

and

z ,i

= 0.

Investors
Lenders are:
risk neutral, behave competitively, supply any quantity of funds demanded at a price Qt ,
Lenders maximize expected prots QB + 1 1+r B , where denotes the expected default probability (zero recovery in case of default).

Thus bond prices satisfy: Q= 1 . 1+r

Recursive Equilibrium
State variables:
x = [y i , s ] , Markovian with conditional density f (x , x ). B is the quantity of debt coming to maturity.

Value of the option to default or stay in the contract is: v o (B , x ) = max {v c (B , B , x ), v d (x )} Value of default is: v d (x ) = u (y def ) +
x

[ v o (0, x ) + (1 )v d (x )]f (x , x )dx

Value of staying in the contract is: v c (B , x ) = MaxB {u (c ) + v o (B , x )f (x , x )dx }

x

Equilibrium Interest Rate in Arellano (2008)

EMBI Global Market Value

EMBI Global Market Value 300

EMBI G Market Value (in billions USD)

250

200

150

100

50

0 1992

1994

1996

1998 2000 2002 Source: Datastream

2004

2006

2008

EMBI Spreads and Standard & Poors Credit Ratings

EMBI G and S&P Ratings as of May 2009 3500

3000

ECU

2500
EMBI G Spread (basis points)

2000
BEL

1500
VEN ARG PAK UKR

1000
DOM KAZ

500
BUL RUS CHIL CHI MAL POL SOU MEX COL HUN PAN BRA TUN PER EGY

EL VIE

SER IND URU PHI

LEB

BBB

BB S&P Ratings

CCC

CC

Is It All About Default Probabilities?

Think about a one-period zero-coupon sovereign bond. Let r f denote the real risk-free rate, r the return on the sovereign bond, p the default probability and rec the recovery rate in case of defaults. Invest one dollar in a risk-free asset or in a sovereign bond. If investors are risk-neutral, expected returns are the same: 1 + r f = (1 p ) (1 + r ) + p rec
NB: We observe r f and r . If we assume a value for rec , then we can compute p : r rf p= 1 + r rec

Then expected excess returns should be zero: Not true in the data!

Back to the Euler Equation

Pt = Et [Mt +1 Xt +1 ]
Pt : price 1-period zero-coupon bond (face value = 1), Mt +1 : investors stochastic discount factor (SDF), Xt +1 : indicator function (1 if repayment, 0 if default).

We can express the bond price as: Pt = Et (Xt +1 ) + covt (Mt +1 , Xt +1 ), Rtf

where Rtf = 1/Et (Mt +1 ) is the risk-free rate. Pt depends on:

discounted payo, risk adjustment component.
Example: CDX, cf Coval, Jurek, and Staord (2009)

No, Risk Matters!

Heres the intuition: Emerging countries tend to default when they are in trouble (i.e in bad times for them). Take two countries: Mexico and Thailand. Assume that they have the same default probability.
Bad times in Mexico are likely to correspond to bad times in the US, Less so for Thailand.

For a given identical default probability, Mexican sovereign bonds are more risky than Thai bonds for the US investor.

Sovereign Risk Premia: Borri and Verdelhan (2012)

Study:
sovereign debt issued by emerging and developing countries in US dollars.

Focus on benchmark JP Morgan EMBI indices. Take the perspective of a US investor.

Findings
Large cross section of average holding period excess returns between countries with low and high probability of default and low and high connection to the US:
Use Standard and Poors credit ratings to measure default probability; Use bond market betas to measure connection to the US.

These excess returns are risk premia.

One single risk factor, the BBB US corporate bond return, explains the cross sectional variation in average excess returns.

A model with optimal sovereign borrowing and default and external habit preferences replicates qualitatively these results.
Pure Peso explanations of excess returns unlikely in simulated data; Risk premia link countries: countries default more frequently when investors risk aversion is high.

Key Mechanism
Investors risk aversion aects debt quantities and prices:
Take the example of countries with business cycles positively correlated to the US These countries are riskier (i.e tend to default in bad times) higher excess returns They are more likely to default when investors risk aversion is high
Every period, tradeo between paying back debt and borrowing again vs default If investors risk aversion is high, risk premia are high, and so are borrowing costs Borrowing again is less attractive, and thus defaults are more likely.

Opening up capital markets exposes emerging countries to US business cycle risk.

Data: EMBI Returns

Data from JP Morgan EMBI Global. EMBI Global is the most liquid US-dollar emerging market index Start from daily return price data in US dollars. Build end-of-month series from December 1993 to May 2011. Sample of 41 emerging countries:
Argentina, Belize, Brazil, Bulgaria, Chile, China, Colombia, Cote DIvoire, Croatia, Dominican Republic, Ecuador, Egypt, El Salvador, Gabon, Ghana, Hungary, Indonesia, Iraq, Kazakhstan, Lebanon, Malaysia, Mexico, Morocco, Pakistan, Panama, Peru, Philippines, Poland, Russia, Serbia, South Africa, South Korea, Sri Lanka, Thailand, Trinidad and Tobago, Tunisia, Turkey, Ukraine, Uruguay, Venezuela, Vietnam.

EMBI Excess Returns and Market Betas

Log excess return on buying country i s EMBI bond at date t and selling it at date t + 1:
,i i i f rte+ 1 = pt +1 pt rt .

p i : Country i log bond price in US dollars. r f : US risk free rate in US dollars.

Market beta iEMBI : slope coecient in the regression:

,i e ,m i i rte+ 1 = + EMBI rt +1 + t +1 .

r e ,m log total excess return on MSCI US equity index Betas are computed on 200-day rolling windows iEMBI ,t .

Data: Default Probability

Data from Standard and Poors. Start from S&Ps credit ratings for foreign currency denominated long-term debt. Convert letter grade credit ratings into numerical index (1 to 23, a higher number means a higher probability of default).

EMBI Portfolios
Countries are ranked on two dimensions:
their default probabilities, their bond market betas.

At the end of each month t , sort all countries into 2 groups on the basis of their iEMBI ,t (information up to date t ). Within each group, sort countries into 3 portfolios on the basis of their default probabilities at the end of each month t .
,j Compute the log excess return rte+ 1 for each portfolio j = 1, 2, ..., 6 by averaging: 1 ,j ,i rte+ rte+ 1 = 1. Nj i Pj

Cross-section of Excess Returns

Portfolios jEMBI S &P Mean Std. Dev. 1 Low 0.09 0.16 2 3 4 5 Low High Medium High Low Medium EMBI Bond Market Beta: jEMBI 0.13 0.10 0.39 0.47 0.20 0.20 0.33 0.31 S&P Default Rating: dp j 9.60 13.10 10.05 12.25 1.00 1.03 1.68 0.96 Excess Return: r e ,j 6.92 8.44 [2.76] [2.98] 11.42 11.80 0.61 0.71 Debt/GNP 0.33 0.27 0.08 0.09 6 High 0.64 0.38

Mean Std. Dev.

7.15 1.52

15.22 1.47

Mean s.e Std. Dev. SR

3.75 [1.75] 7.34 0.51

4.13 [2.15] 9.08 0.45

8.78 [3.90] 15.25 0.58

14.62 [5.09] 20.72 0.71

Mean Std. Dev.

0.11 0.05

0.16 0.09

0.30 0.08

0.33 0.09

Annualized monthly excess returns. Monthly Data. Higher S&Ps credit ratings is higher default probability. Sample period is 1/1995 5/2011.

Spreads in Sovereign Bond Returns

Spreads between high and low default probability countries: 470 bp on average.

Spreads between high and low bond market beta countries: 570 bp on average.

Cross-Sectional Asset Pricing

,j Rte+ 1 has a zero price: ,j E [Mt +1 Rte+ 1 ] = 0.

where M is the stochastic discount factor of US investors. M is linear in the pricing factors f : Mt +1 = 1 b (ft +1 ), where b is the vector of factor loadings. Candidate risk factors:
returns on US stock market; returns on US corporate bond market: USBBB .

No Arbitrage Restrictions

The Euler equation E [MR e ,j ] = E [R e ,j b (f )R e ,j ] = 0 implies that: E [(f )R e ,j ] E [ R e ,j ] = b . -pricing model: E [ R e ,j ] = j .

where = b and = E (ft f )(ft f ) is the variance-covariance matrix of the factors.

No arbitrage implies:
e Risk Factor = E [RRisk Factor ]

Model Fit: The Left Panel is Misleading...

16 16

6
14
Actual Mean Excess Return (in %)

6
14
Actual Mean Excess Return (in %)

12 10

12 10

4
8 6 41 2

4
8 6 4 2

12

10

15

10

15

Predicted Mean Excess Return (in %)

Predicted Mean Excess Return (in %)

Risk Prices

US BBB FMB 7.22 [2.49] (2.58) 4.43 [1.84]

bUS BBB 1.64 [0.56] (0.59)

R2 84.38

RMSE 1.31

54.08 60.38

Mean

s? Signicant s?
Portfolio 1 2 3 4 5 6 All j 0 (%) jUS BBB 0.76 [0.09] 0.85 [0.12] 0.87 [0.13] 1.06 [0.16] 1.31 [0.20] 1.84 [0.38] R 2 (%) 38.93 32.14 21.31 29.44 27.07 28.93 5.79 44.69 2 ( ) p value

0.17 [0.12] 0.20 [0.19] 0.02 [0.23] 0.03 [0.25] 0.10 [0.30] 0.05 [0.50]

Conditional Asset Pricing

Conditional Euler equation:
,j Et [Mt +1 zt Rte+ 1 ] = 0,

to test this prediction.

,j zt Rte+ 1 is a managed portfolio.

zt is the CBOE volatility index VIX and summarizes all the information set of the investor.

The market prices of risk associated with the USBBB factor increase in bad times, when the implied US stock market volatility is high.

Conditional Asset Pricing

USBBB FMB 5.00 [3.47] (3.57) 4.43 [1.84]

USBBB VIX 20.68 [8.62] (8.79) 18.87 [6.26]

bUSBBB

bUSBBB VIX 0.39 [0.69] (0.72)

R2 90.48

RMSE 3.39

0.20 [2.98] (3.08)

2.52 3.90

Mean

Asset Pricing Summary

Risk is priced on sovereign bond markets:

Large cross-section of excess returns No arbitrage condition not rejected:
Estimated market price of risk higher but not statistically dierent from the mean of the risk factor (NB: no transaction costs here.)

Higher risk premia in bad times

Macro Implications?
Cost of debt, borrowing and default choice are all endogenous. We need a model of optimal sovereign borrowing and default:
N-1 small open economies (borrowers), 1 large developed economy (US, lender), Framework a la Eaton and Gersovitz (1981), Aguiar and Gopinath (2006) and Arellano (2008), But:
Lenders are risk-averse: external habit preferences as in Campbell and Cochrane (1999). The borrowers endowment is composed of a transitory component and a time-varying mean. One source of heterogeneity among borrowers: countries dier in their correlation with respect to the US business cycle.

Why External Habits?

Models with power utility preferences do not produce large spreads in excess returns. Intuition:
Assume same probability of default, same yield volatility.
e ,j e ,i Spreads depend on covt (Mt +1 , Rt +1 ) covt (Mt +1 , Rt +1 ).

Maximum spreads between high and low-correlation countries: 2c r e 2 2 1.5% 13% 80bp .

Matching the data with CRRA implies a very high risk-aversion coecient and implausible risk-free rates.

External habit implies that risk aversion is time-varying and higher in bad times.

Endowment: lenders

US consumption growth is a random walk: ct = g +

t.

Emerging countries only dier according to their conditional correlation to the developed economy: E(
zi

) = i .

Investors
Lenders are:
risk averse, behave competitively, supply any quantity of funds demanded at a price Qt , have external habit preferences over their consumption endowment described by: (Ct Ht )1 1 Et ( ) t . 1 t =0 Ht is the external habit level and corresponds to a time-varying subsistence level or social externality.

If lenders were risk neutral, there would be no role for covariances in sovereign bond prices.

Model Parameters
Variable Lenders Risk-aversion Mean consumption growth (%) Standard deviation of consumption growth (%) Persistence of the surplus consumption ratio Mean risk-free rate (%) Borrowers Endowment Permanent: Persistence Permanent: Standard deviation (%) Permanent: Mean (%) Temporary: Persistence Temporary: Standard deviation (%) Temporary: Mean (%) Preferences Risk-aversion Discount factor Direct default cost (%) Probability of re-entry (%) g rf 2.00 1.89 1.50 0.87 1.00 Notation Value

g g g z z z

0.20 4.00 2.31 0.90 2.00 Var (z )/2 2.00 0.80 4.00 10.00

Results

A model with both large sovereign debt levels and large spreads:
time-varying mean growth rates incentives to borrow (e.g., good times ahead, but want to consume now) large debt But, sometimes, ... unexpected bad news (e.g., negative temporary shocks) defaults large spreads

Defaults and bond prices depend not only on the borrowers, but also on the lenders economic conditions

Key Mechanism, Again

Investors risk aversion aect debt quantities and prices:
Take the example of countries with business cycles positively correlated to the US These countries are riskier (e.g tend to default in bad times) higher excess returns They are more likely to default when investors risk aversion is high
Every period, tradeo between paying back debt and borrowing again vs default If investors risk aversion is high, risk premia are high, and so are borrowing costs Borrowing again is less attractive, and thus defaults are more likely.

Default Frontiers
Default Policy Sets (Defaults occur in the area below the frontier)
Low mean growth rate (g), high riskaversion (low s) Low mean growth rate (g), low riskaversion (high s) High mean growth rate (g), high riskaversion (low s) High mean growth rate (g), low riskaversion (high s)

0.06

0.04

Endowment shock z

0.02

0.02

0.04

0.06 0.5 0.45 0.4 0.35 0.3 0.25 Debt level B today 0.2 0.15 0.1

Sovereign Bond Prices

Impact of growth rates 1
low z, low g low z, high g high z, low g high z, high g

Impact of riskaversion 1
low z low z, no r.p. high z high z, no r.p.

0.9

0.9

0.8

0.8

0.7

0.7

0.6

0.6

Bond price Q

0.5

Bond price Q
0.3 0.2 Debt level B tomorrow 0.1

0.5

0.4

0.4

0.3

0.3

0.2

0.2

0.1

0.1

0 0.4

0 0.4

0.3 0.2 Debt level B tomorrow

0.1

Simulated Data
Generate simulated data for 36 small open economies. The only source of heterogeneity across countries is the correlation of their endowment process with the US endowment.
Correlations range from -0.5 to 0.5.

Sort bonds only on one dimension.

In the model, precise measures of expected default probabilities and consumption correlations. But this is a one-factor model: one source of risk is priced (correlation between US endowment shocks and bond returns). Similar results when using simulated stock market betas.

Additional potential source of heterogeneity: endowment volatility.

Portfolios - Simulated Data

Portfolios Mean Std Mean Std Mean Std Std* Mean Std Mean Std 1 2 3 4 5 6 Stock market beta: Mkt (Pre-Formation) 0.25 0.12 0.05 0.00 0.05 0.13 0.20 0.15 0.11 0.10 0.10 0.13 Default probability 5.85 5.41 4.89 4.50 4.17 3.84 1.33 1.21 1.09 1.02 0.96 0.91 e Excess return: r 1.24 0.66 0.14 0.29 0.52 0.65 21.06 19.73 18.64 17.88 17.28 16.68 1.02 1.01 1.01 1.02 1.03 1.04 Debt/Output 30.14 29.71 29.29 29.01 28.67 28.52 7.09 6.92 6.78 6.73 6.73 6.67 Stock market beta: Mkt (Post-Formation) 0.14 0.08 0.04 0.00 0.03 0.05 0.01 0.01 0.01 0.01 0.01 0.01

Simulation Results

Reasonable consumption and output dynamics, and large debt/GDP ratios A cross-section of sovereign bond excess returns...
smaller than in the data (180 bp vs 500 bp)
reminder: only one-quarter bonds, no term premium

as in the data, high excess returns

do not correspond to higher debt levels, but correspond to higher stock market betas

... that corresponds to risk premia.

Risk-Neutral Investors and Peso Explanation?

Portfolios 2 3 4 5 6 Panel I: Low-Default-Probability Sample Stock market beta: Mkt 0.36 0.05 0.01 0.00 0.03 0.27 Default probability 2.35 2.33 2.30 2.27 2.29 2.29 Excess return: r e 2.44 2.47 2.51 2.53 2.50 2.50 6.80 6.73 6.69 6.64 6.68 5.57 Panel II: Full Sample Stock market beta: Mkt 0.01 0.01 0.01 0.01 0.01 0.01 Default probability 5.15 5.15 5.15 5.15 5.15 5.15 Excess return: r e 0.00 0.00 0.00 0.00 0.00 0.00 22.91 22.91 22.91 22.91 22.91 22.91 1

Mean Mean Mean Std

Mean Mean Mean Std

Implications

Interest rate elasticity of debt:

No monotonic increase in interest rates when debt levels increase.

Output-interest rate correlations:

Depends on the cross-country correlation of business cycles.

Monetary unions:
More synchronized business cycles higher sovereign risk premia.

Conclusion
Empirically, countries with higher bond betas oer higher returns.
Timing of expected sovereign payos matters. Low payos in bad times = risky sovereign bonds.

Models of optimal borrowing and defaults with risk neutral investors cannot account for our empirical ndings. Investors risk aversion aect optimal debt quantities and prices.
Habit preferences lead to a cross-section of sovereign bond excess returns. Riskier countries are more likely to default when investors risk aversion is high.

Opening up capital markets exposes emerging countries to US business cycle risk.