Indeterminacy in Sovereign Debt Markets: An Empirical Investigation

Alessandro Dovis and Luigi Bocola
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Alessandro Dovis: Pennsylvania State University

No 694, 2015 Meeting Papers from Society for Economic Dynamics

Abstract: How important was non-fundamental risk in driving interest rate spreads during the euro-area sovereign debt crisis? To answer this question, we consider a quantitative model of sovereign borrowing with three key ingredients: multiple debt maturities, risk averse lenders and coordination failures a la Cole and Kehoe (2000). In this environment, lenders' expectations of a default can be self-fulfilling, and market sentiments contribute to variation in interest rate spreads along with economic fundamentals. We show that the joint distribution of interest rate spreads and debt duration provides information to distinguish between these two sources of default risk. We make use of this result by calibrating the model to match the empirical distribution of Italian sovereign spreads and debt duration. The process for the lenders' stochastic discount factor, a key input in our analysis, is disciplined using moments from the yield curve on safe assets and the euro-area stock price-consumption ratio. Our preliminary results indicate that the rise in Italian interest rate spreads over the 2011-2012 period was mostly the result of bad economic fundamentals and high risk premia, with a limited role played by non-fundamental uncertainty. We show how this information can be used to understand the implications of the OMT program announced by the ECB.

Date: 2015
New Economics Papers: this item is included in nep-dge and nep-mac
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