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Sovereign Risk Matters: The Effects of Endogenous Default Risk on the Time-Varying Volatility of Interest Rate Spreads

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Abstract
Emerging market interest rate spreads display substantial time-varying volatility. We show that a baseline model with endogenous sovereign default risk can account for such volatility, even in the absence of shocks to the second moments of the exogenous stochastic variables. In particular, the model features a key non-linearity that allows it to replicate the volatility of interest rate spreads and its comovement with other economic variables. Volatility correlates positively with the level of the spreads and the trade balance and negatively with output and consumption.

Suggested Citation

  • Sergio De Ferra & Enrico Mallucci, 2020. "Sovereign Risk Matters: The Effects of Endogenous Default Risk on the Time-Varying Volatility of Interest Rate Spreads," International Finance Discussion Papers 1276, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:1276
    DOI: 10.17016/IFDP.2020.1276
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    More about this item

    Keywords

    Sovereign risk; Time-varying volatility; Interest rates;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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