Sovereign Risk Premia

Abstract

Emerging countries tend to default when their economic conditions worsen. If bad times in an emerging country correspond to bad times for the US investor, then these foreign sovereign bonds are particularly risky and should offer high returns. We explore how this mechanism plays out in the data and in a general equilibrium model of optimal borrowing and default. Empirically, the higher the correlation between past foreign and US bond returns, the higher the average sovereign excess returns. A model of risk-averse lenders with external habit preferences replicates this feature. and illustrates the impact of risk premia on optimal debt quantities, defaults and prices.