Ignacio Presno | Searcharxiv

arXiv2015

Sovereign Default Risk and Uncertainty Premia

This paper studies how international investors' concerns about model misspecification affect sovereign bond spreads. We develop a general equilibrium model of sovereign debt with endogenous default wherein investors fear that the probability model of the underlying state of the borrowing economy is misspecified. Consequently, investors demand higher returns on their bond holdings to compensate for the default risk in the context of uncertainty. In contrast with the existing literature on sovereign default, we match the bond spreads dynamics observed in the data together with other business cycle features for Argentina, while preserving the default frequency at historical low levels.

econ.GN↗

arXiv2015

Optimal Taxation with Endogenous Default under Incomplete Markets

In a dynamic economy, we characterize the fiscal policy of the government when it levies distortionary taxes and issues defaultable bonds to finance its stochastic expenditure. Default may occur in equilibrium as it prevents the government from incurring in future tax distortions that would come along with the service of the debt. Households anticipate the possibility of default generating endogenous credit limits. These limits hinder the government's ability to smooth taxes using debt, implying more volatile and less serially correlated fiscal policies, higher borrowing costs and lower levels of indebtedness. In order to exit temporary financial autarky following a default event, the government has to repay a random fraction of the defaulted debt. We show that the optimal fiscal and renegotiation policies have implications aligned with the data.

econ.GN↗