Sovereign Default Risk and Uncertainty Premia

Abstract

This paper develops a general equilibrium model of sovereign debt with endogenous default. Foreign lenders fear that the probability model which dictates the evolution of the endowment of the borrower is misspecified. To compensate for the risk and uncertainty adjusted probability of default, they demand higher returns on their bond holdings. In contrast with the existing literature on sovereign default, we are able to match the average bond spreads observed in the data together with the standard empirical regularities of emerging economies. The technical contribution of the paper lies in extending the methodology of McFadden (1981) to compute equilibrium allocations and prices using the discrete state space (DSS) technique in the context of risk and uncertainty aversion on the lenders' side.