Default risk and risk averse international investors

Abstract

This paper develops a model of debt and default for small open economies that interact with risk averse international investors. The model developed here extends the recent work on the analysis of endogenous default risk to the case in which international investors are risk averse agents with decreasing absolute risk aversion (DARA). By incorporating risk averse investors who trade with a single emerging economy, the present model offers two main improvements over the standard case of risk neutral investors: i.) the model exhibits a better fit of debt-to-output ratio and ii.) the model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets. The paper shows that if investors have DARA preferences, then the emerging economy's default risk, capital flows, bond prices and consumption are a function not only of the fundamentals of the economy-as in the case of risk neutral investors-but also of the level of financial wealth and risk aversion of the international investors. In particular, as investors become wealthier or less risk averse, the emerging economy becomes less credit constrained. As a result, the emerging economy's default risk is lower, and its bond prices and capital inflows are higher. Additionally, with risk averse investors, the risk premium in the asset prices of the sovereign countries can be decomposed into two components: a base premium that compensates the investors for the probability of default (as in the risk neutral case) and an "excess" premium that compensates them for taking the risk of default.

Sovereign Default Risk and Uncertainty Premia

“…See Table S.52 for details. Our results are also consistent with the findings by Lizarazo (2013) and Borri and Verdelhan (2010). Even if sufficiently high values of risk aversion could eventually recover the high spreads shown in the data, doing so, however, would lower the risk-free rate to levels far below those exhibited in the data, in line with Weil (1989) risk-free rate puzzle.…”

“…With constant relative risk aversion, as in Lizarazo (2013), matching high spreads calls for a very large risk aversion coefficient and implausible risk-free rates. 53 Our model can also generate considerable levels of borrowing, consistent with levels observed in the data.…”

“…Chat-terjee and Eyingungor (2012) introduced long-term debt in these environments. 8 Lizarazo (2013) endows the lenders with constant relative risk aversion (CRRA) preferences. Borri and Verdelhan (2010) has studied the setup with positive correlation between lenders' consumption and output in the emerging economy in addition to time-varying risk aversion on the lenders' side as a result of habit formation.…”

IMF conditionalities, liquidity provision, and incentives for fiscal adjustment

“…3 In most of the literature, creditors are risk neutral, so the domestic economy can always borrow at the actuarially fair price. Lizarazo (2013) considers the case with risk averse lenders, which generates a risk premium in the model.…”

Sovereign Risk Contagion

“…These papers analyze the case of risk-neutral lenders, abstract from recovery, and focus on the default experiences of single countries. Borri and Verdelhan (2009) and Lizarazo (2013) study the case of risk-averse lenders, and Pouzo and Presno (2011) study the case of lenders with uncertainty aversion. They show that deviations from risk neutrality allow the model to generate spreads that are larger than default probabilities, which is a feature of the data.…”