Sovereign Risk Premia

Emerging countries tend to default when their economic conditions worsen. If harsh economic conditions in an emerging country correspond to similar conditions for the U.S. investor, then foreign sovereign bonds are particularly risky. We explore how this mechanism impacts the data and influences a model of optimal borrowing and default. Empirically, the higher the correlation between past foreign bond and U.S. market returns, the higher the average sovereign excess returns. The market price of sovereign risk appears in line with its corporate counterpart. In the model, sovereign defaults and bond prices depend not only on the borrowers' economic conditions, but also on the lenders' time-varying risk aversion.