The Dynamics of Sovereign Credit Risk

Alexandre Jeanneret ⇤†

HEC Montréal

June 25, 2013

⇤
Acknowledgments: I am deeply grateful to Darrell Duffie, Bernard Dumas and Rajna Gibson for insight-
ful discussions and suggestions. I am also especially thankful to an anonymous referee for many helpful and
constructive comments. This paper has also greatly benefited from suggestions provided by Daniel Andrei,
Tony Berrada, Tim Bollerslev, Ricardo J. Caballero, John Y. Campbell, Georges Dionne, Engelbert Dock-
ner (discussant), Christian Dorion, Pascal François, Jeffrey A. Frankel, Rüdiger Frey (discussant), Ricardo
Hausmann, Michael Hutchison, Jean Imbs, Eric Jondeau, Philippe Jorion, Manuel Mayer, Robert C. Merton,
Jean-Sebastien Michel, Erwan Morellec, Roberto Rigobon, Jean-Guy Simonato, Ilya Strebulaev (discussant),
René Stulz, Michael Waibel, Jin-Huei Yeh (discussant), Vivian Yue, participants of the 2007 Paris Finance Inter-
national Meeting, the 2008 Financial Risks International Forum on Structured Products and Credit Derivatives,
the 2008 Derivatives Securities and Risk Management FDIC Conference, the 2008 Swiss Doctoral Workshop in
Finance, the 2009 European Finance Association, the 2009 Risk Management Conference, the 2012 CREDIT
Conference, the 2013 WU Gutmann Center Symposium, and seminar participants at Harvard University, Queen’s
University, UC Santa Cruz, University of Geneva, University of Lausanne, and University of Zurich. I acknowledge
the financial support from Swiss Finance Institute and the NCCR FINRISK, managed by the Swiss National
Science Foundation, HEC Montréal, Institut de Finance Mathématique de Montréal (IFM2), and the Fonds
Québécois de la Recherche sur la Société et la Culture (FQRSC). All errors, conclusions and opinions contained
herein are solely those of the author.
†
Contact details: HEC Montréal, Department of Finance, 3000 Côte-Sainte-Catherine, Montréal, Canada
H3T 2A7. E-mail: alexandre.jeanneret@hec.ca. Website: www.alexandrejeanneret.com
 The Dynamics of Sovereign Credit Risk

ABSTRACT

This paper proposes a structural model for sovereign credit risk with endogenous sovereign
debt and default policies. A maximum-likelihood estimation of the model with local stock mar-
ket prices generates daily model-implied sovereign spreads. This approach explains two-thirds
of the daily variation in observed sovereign spreads for emerging and European economies over
the 2000-2011 period. Global factors help to further explain the time variation in sovereign
credit risk. In particular, sovereign spreads in emerging markets vary with U.S. market uncer-
tainty, while European spreads depend on Euro zone bond factors.

JEL Codes: F31, F34, G12, G13, G15

Keywords: Sovereign Debt, Volatility, Credit Risk, Asset Pricing, International Financial Markets
I Introduction

The widespread rise in sovereign credit risk, recently illustrated by the 2010-2012 European
sovereign debt crisis and the downgrade of U.S. debt in August 2011, has become a major
concern in global financial markets.1 Investors pay increasing attention to the assessment of
the risk embedded in sovereign debt, one of the largest asset classes in the world with $42
trillion in principal.2 Understanding the time variation in sovereign credit risk is therefore of
the utmost importance today. The aim of this paper is to develop a framework that provides
useful guidance on sovereign credit risk and to investigate how its dynamics differs among
emerging and European countries.
This paper extends our knowledge of the pricing of sovereign default risk, with an analysis
of the 2000-2011 period spanning the recent European debt crisis. The contribution of the
paper is twofold. First, it proposes a new structural model for sovereign credit risk that
jointly determines the optimal sovereign debt policy and the timing of sovereign default. The
model provides an analytical formula for sovereign credit spreads that can easily be compared
to observed spreads. Second, this study shows that the information embedded in the local
stock market can be used jointly with the pricing model to explain the daily variation in
sovereign credit spreads for large emerging and European debt issuers. Results are robust for
12 countries and hold before and during the 2010-2011 European debt crisis.
The theoretical model consists of an economy with a representative firm and a govern-
ment. The firm pays income taxes to the government, which are used to service sovereign
debt. The government chooses an optimal level of debt that arises from a trade-off between
the economic benefits of the debt issue (e.g., return on public investment) and the expected
cost of default (e.g., economic contraction). Building on the contingent claims approach,
1
The financial press regularly reports the negative consequences of European sovereign credit risk on inter-
national stock markets. Recent articles include “Greek fears hit global stocks, bond spreads” (Reuters, April
8, 2010), “Global Markets Tumble on Continued Worries Over Europe’s Debt Crisis” (The New York Times,
July 11, 2011), and “Dow Drops 520 Amid New Europe Debt Concern” (Bloomberg, August 11, 2011), among
others.
2
Quarterly statistics on domestic and international sovereign debt can be found in Tables 12D and 16A of
the BIS website (http://www.bis.org/statistics/secstats.htm).

1
sovereign default is triggered when firm asset value (equal to the present value of firm in-
come) falls below an endogenous boundary, which characterizes the government’s default
policy. This policy is determined by the trade-off between the cost of default and the level
of debt that is reduced through debt restructuring. The model provides a unified framework
to derive, under optimal debt and default policies, a country’s stock price and its sovereign
credit spread.
The novel empirical approach of the paper is to use the model to structurally extract
the unobservable firm asset value from local stock market prices. This information can then
be used to generate model-implied sovereign spreads at any frequency. Another advantage
is to benefit from forward-looking information, since the stock market qualifies as a natural
predictor of the business cycle (Fischer and Merton, 1985).3 In comparison, data on govern-
ment fiscal revenues, firm income, or economic output are observable at low frequency and
contain past information only. Moreover, the model breaks down the non-linear relationship
between stock prices and sovereign spreads and generates credit spreads that are linearly
related - and thus comparable - to observed sovereign spreads. This approach thus combines
the forward-looking property of local stock market prices and a structural model to compute
daily sovereign credit spreads.
The key parameters of the model are estimated by maximum likelihood in a two-stage
procedure. The first stage relates to the estimation of the dynamics of the firm asset value
using local stock market prices, following the methodology developed by Duan (1994) and
Ericsson and Reneby (2005). The second stage estimates, using data from the credit mar-
ket, the government’s benefits of issuing debt, captured by the return on public investment.
The estimated level of asset volatility is, on average, 35% in emerging markets and 23%
in European countries.4 The difference in estimates between the two groups of countries is
3
Fama (1981, 1990), Chen, Roll, and Ross (1986), and Schwert (1990) provide further evidence that stock
market prices are strongly related to aggregate economic activity in the U.S. Similarly, Asprem (1989), Ferson
and Harvey (1993), and Cheung and Ng (1998) investigate international equity returns and find that a country’s
stock market is strongly linked to local economic indicators.
4
The historical asset value growth rate is also estimated, though it is not relevant for the pricing of securities.

2
in line with the intuition that European countries present lower economic uncertainty than
emerging countries. The estimated rate of return on public investment is, on average, 2.52%
in emerging countries and 0.26% in Europe. Emerging economies thus offer enhanced in-
vestment opportunities compared to European countries. All coefficient estimates are highly
statistically significant.
These estimates are used to generate daily model-implied credit spreads for each country
over the period 2000-2011, which are then compared to those in the data. The benchmark
credit spreads are given by the Emerging Markets Bond Index (EMBI+) for emerging countries
and by the difference between 10-year government bond yields and a risk-free benchmark for
European countries. Overall, the model-implied spreads match the level and the volatility of
observed sovereign spreads over quiet and crisis periods, and across countries.
A central result of the paper is that the model credit spreads, using local stock market
information, can explain a substantial fraction of the variation across time in sovereign credit
risk. Using a panel data analysis, the model-implied credit spreads explain 66% and 69% of
the daily variation in emerging and European spreads, respectively. The pricing model helps
us understand the dynamics of sovereign spreads without considering information related
to other classes of agents (e.g., personal consumption, international trade taxes, exchange
rates). This result suggests that the local stock market is a powerful aggregator of the
information relevant to the valuation of sovereign credit risk.
The local stock market information alone is yet not sufficient to adequately explain the
dynamics of sovereign spreads. When replacing the model credit spreads by the local stock
market index, the explanatory power drops to 28% and 15%, respectively. The model’s good
performance arises from its ability to account for the highly non-linear relationship between
stock market information and sovereign credit risk, thereby generating credit spreads that are
linearly related to observed sovereign spreads. The discrepancy in performance illustrates the
importance of using a structural approach for the modeling of sovereign credit risk.
The model explains a large fraction of the time variation in sovereign credit spreads.

3
However, Pan and Singleton (2008), Remolona, Scatigna, and Wu (2008), Hilscher and Nos-
busch (2010), and Longstaff, Pan, Pedersen, and Singleton (2011) suggest that variations in
sovereign credit risk can be largely attributed to changes in common factors across countries.
For example, the option-implied volatility index (VIX), which measures the level of uncertainty
in the U.S. equity market, is found to be a key factor in their explanation of sovereign credit
risk.
It is thus insightful to determine the amount of information that the model credit spreads
capture and to compare it with that of relevant market-wide factors. To this end, I analyze
the information contained in the model spreads in a regression that additionally includes U.S.
global factors, such as the option-implied volatility of the equity market (VIX), the short rate
(3-month), the U.S. Treasury yield (10-year), and the slope of the yield curve (30-year minus
3-month rates). I also consider the European counterparts of these factors, which are the
option-implied volatility on the EuroStoxx 50 index (VSTOXX) and the levels and the slope
of the German Bund term structure.
The model-implied spreads hold their economic and statistical significance when the anal-
ysis accounts for these market-wide factors. In addition, the model spreads alone explain 91%
and 97% of the total variation explained in emerging markets and in Euro member states.5
Therefore, the structural model accounts for a single source of information but captures a
relatively important part of the time variation in sovereign credit spreads, in particular for
large sovereign debt issuers with liquid credit and equity markets.
The residual variation in sovereign credit risk exhibits a sensitivity to global market fac-
tors that differs considerably across European and emerging countries. The level of market
uncertainty (VIX) greatly widens emerging spreads but has no impact on European spreads.
Similar results obtain with the VSTOXX. The U.S. Treasury market does not help explain
European and emerging spreads, but European sovereign spreads appear rather sensitive to
5
To calculate this measure, I first regress the observed sovereign spreads on model spreads, and then divide
the R2 from this regression by the adjusted R2 from the regression that includes the model spreads and the
additional factors. This approach follows Longstaff et al. (2011).

4
the Euro bond market. In particular, the slope of the German Bund term structure reduces
the costs of debt in Euro member states (i.e., improved economic outlook), whereas a high
10-year Bund yield is associated with wide European spreads (i.e., greater costs of long-term
financing). Finally, the 3-month rate, which proxies short-term funding costs, is not statis-
tically significant. Hence, the European debt crisis seems to be related to a solvency rather
than a liquidity crisis.
Overall, the pricing of sovereign credit risk in emerging countries varies with global market
uncertainty, while European credit risk rather depends on expectations embedded in the Euro
zone bond market. The European debt crisis essentially differs from the emerging market
experience by its political nature and its international dimension. In particular, the long-
lasting recession in Europe combined with additional austerity measures, the debate around
the European Central Bank’s intervention in the secondary bond market, the willingness of
European banks to accept, or not, voluntary debt restructurings, and the disagreements
between European leaders on policies to prevent contagion in the default crisis, for example,
are likely to affect European sovereign credit spreads beyond the level of volatility in financial
markets.
This paper contributes to a growing literature that aims to better understand and quantify
the risk of sovereign default. The results of this study suggest that a pricing model with
endogenous debt and default policies can be conveniently applied to the data to generate
credit spreads that closely match market spreads. A new feature of this paper is to extract
the forward-looking information embedded in domestic stock prices. This approach thus
offers an explanation of the substantial daily variation in sovereign credit risk that cannot be
explained by conventional economic measures, which are only available quarterly or annually.
The rest of the paper is organized as follows. Section II reviews the literature relevant
to this study. Section III outlines a structural model for sovereign debt with endogenous
debt and default policies. Section IV presents the data used in the empirical study, Section
V describes the estimation of the model, while Section VI examines the model’s ability to

5
explain the time variation in sovereign credit spreads. I conclude the analysis in Section VII.

II Related Literature

Various studies are related to the empirical analysis of the paper. Duffie, Pedersen, and
Singleton (2003) and Pan and Singleton (2008) consider a reduced-form affine-structure
model to study weekly and daily sovereign spreads, respectively. Other studies investigate
monthly credit spreads using a reduced-form contingent-claims analysis (Bodie, Gray, and
Merton, 2007; Gapen, Gray, Lim, and Xiao, 2008), a structural model of the balance sheets
(François, Hübner, and Sibille, 2011), a principal components analysis (Longstaff et al.,
2011), or a linear regression model (Remolona et al., 2008). Another strand of studies
analyzes the dynamics of quarterly or annual credit spreads in a dynamic stochastic equilibrium
model (e.g., Arellano, 2008; Yue, 2010) or with a panel-based approach (e.g., Hilscher and
Nosbusch, 2010, and the references therein). An advantage of the present paper is to provide
a new theoretical framework for the analysis of the time variation in credit spreads that can
be applied at any frequency.
A recent strand of research highlights the role of political and institutional dimensions in
explaining sovereign credit risk. For example, Bekaert, Harvey, Lundblad, and Siegel (2012)
find that political risk is an important determinant of sovereign credit spreads in emerging
countries, in line with the results of Baldacci, Gupta, and Mati (2011).6 These characteristics
tend to be persistent over time and are, therefore, mostly relevant to the explanation of the
cross-country variation in sovereign credit risk. While the present paper is devoted to the
time variation in sovereign spreads, both lines of research certainly complement each other
in the understanding of a country’s sovereign credit risk.
On the theoretical side, this paper builds on the foundation laid by several strands of the
literature. One body of literature that was launched with the seminal contributions of Eaton
6
In a similar vein, Cosset and Jeanneret (2013) show that the quality of governments is a central driver of
the cross-country differences in sovereign spreads among emerging and developed countries.

6
and Gersovitz (1981) and Bulow and Rogoff (1989) addresses why sovereign lending takes
place by focusing on the costs of future access to credit, trade, and financial markets, as
well as on retaliatory actions by way of sanctions. With the aim of pricing the risk of gov-
ernment default, a second body of literature driven by Hayri (2000), Gibson and Sundaresan
(2001), Westphalen (2002), Andrade (2009), Jeanneret (2012), Mayer (2102), and Cosset
and Jeanneret (2013) offers models for the valuation of sovereign debt in the presence of
strategic default using a contingent claims framework. Their approach follows the structural
modeling developed in corporate finance, where default is modeled as the event that the
debtor’s cash flows or asset-liability ratio falls below a certain cut-off level for the first time,
as in Fischer, Heinkel, and Zechner (1989) and Leland (1994). While the timing of default is
determined by the government, the debt policy is typically assumed to be exogenous in those
studies. François et al. (2011) extend this literature with a model of renegotiation between
the defaulting government and its lenders. They also highlight how interactions between the
banking sector, firms, and a government help explain Brazilian sovereign spreads. In a dif-
ferent approach, Arellano (2008) and Yue (2010) draw on a dynamic stochastic equilibrium
model to explain the dynamics of Argentinean spreads using quarterly GDP data. Results are
conclusive, but the frequency of the data under analysis remains low. Borri and Verdelhan
(2011) extend this equilibrium model and provide new insights into the market risk premium
embedded in sovereign spreads. Finally, Bodie et al. (2007) and Gapen et al. (2008) highlight
the importance of using higher-frequency, forward-looking data on the economy as provided
by market prices. They use domestic debt price data to evaluate credit spreads on foreign
debt.

7
III Model

This section presents a model for sovereign credit risk with endogenous default and debt
policies. Throughout the paper, capital markets are frictionless and all investors have perfect
information. All variables are measured in the same numeraire.

A Environment

The economy consists of a government and a representative unlevered firm, which are both
infinitely lived. The default-free term structure is flat with an instantaneous risk-free rate r,
at which investors may lend and borrow freely.7 In the absence of government default, the
firm has an asset whose value is governed by the process

(1) dVt = µVt dt + Vt dZt, V0 > 0

where µ and represent constant mean and volatility of the firm’s asset value growth rate, and
Zt is a Brownian motion defined on the probability space (⌦, F , P). The standard filtration
of Zt is F = {Ft : t 0}. The value V represents the discounted value of firm income
generated by the firm’s economic activities. The firm pays income taxes to the government
at a constant rate ⌧ . The discounted value of the government’s fiscal revenue is then given
by ⌧ V .

A.1 Government indebtedness

The government chooses to be indebted and thus commit to service debt. The motivation
for issuing debt is to finance public investments that generate economic value. Return on
public investment is rg per unit of time, and the discounted benefit of issuing one unit of debt
⇥R 1 ⇤
is given by E 0 rg e rt dt = rrg .
7
The risk-free rate is not the government bond rate of the country under study. It should be viewed either as
the equilibrium risk-free rate prevailing in a consumption-based environment or as the rate of another country’s
bond that is risk-free (e.g., the U.S. Treasury rate in U.S. dollar or the German Bund rate in euro).

8
 Since sovereign debt contracts are not subject to enforceable law, the government may
choose to strategically default on its debt obligations. The government’s decision depends
on the trade-off between the gains and the costs of default.

A.2 Gains and costs of default

In the case of default, the government and its lenders restructure the terms of the debt
contract and agree to reduce the debt to service by a fraction 2 [0, 1]. This reduction
in debt service is then the government’s incentive to default. Default, however, is costly
because it leads to a contraction in economic activity, which reduces the firm’s asset by a
fraction 2 [0, 1].8 These default costs constitute the government’s motivation for avoiding
default when unnecessary, thus following a recent literature (e.g., Arellano, 2008; Andrade,
2009; Hatchondo and Martinez, 2009; Yue, 2010; Borri and Verdelhan, 2011).9
The default policy is determined endogenously, based on the trade-off between the gains
and the costs of default. There exists a threshold V D at which it is optimal for the government
to declare default. The intuition for this threshold is that the government has greater incentive
to default when the gain of a reduced debt service outweighs the costs of defaulting, that is
when the economic conditions deteriorate.10 Defaulting thus occurs at time T D = inf{t
0 | Vt  V D }, when the asset value V falls to V D .
I first evaluate the price of sovereign debt for a given default threshold V D and then derive
8
There is ample evidence on the costs of a sovereign default on economic activity (e.g., Reinhart, Rogoff, and
Savastano, 2003; Sturzenegger and Zettelmeyer, 2006). First, debt repudiation leads to a decline in bilateral
trade, thereby hurting export-oriented firms (Rose, 2005; Martinez and Sandleris, 2011). Second, a sovereign
default weakens the domestic financial system. As major creditors of the government, domestic banks may
be prevented from providing liquidity and credit to firms (Acharya, Drechsler, and Schnabl, 2011; Gennaioli,
Martin, and Rossi, 2011). Sovereign default crises have thus been associated with banking crises, which result
in severe and prolonged recessions (De Paoli, Hoggarth, and Saporta, 2006; Reinhart and Rogoff, 2009).
9
Bulow and Rogoff (1989) suggest two additional reasons for a country to repay its foreign debt. First,
lenders may be able to appropriate collateral. However, in the event of repudiation, the assets accessible to
creditors are worth only a small fraction of the outstanding level of debt. Second, there may be a reputation
effect that could impact future borrowing opportunities, though empirical support for such an effect is weak
(Eichengreen, 1989; Gelos, Sahay, and Sandleris, 2011).
10
Sovereign defaults typically occur during economic downturns (see Reinhart et al., 2003; De Paoli et al.,
2006). While sovereign countries can default several times, generalizing the framework to account for multiple
defaults is left for future research.

9
the optimal default and debt policies in the following sections.

B Sovereign Debt Value

The government issues an infinite maturity debt contract, characterized by a level D and a
continuous debt service C until default. In absence of arbitrage opportunities, the expected
return on sovereign debt equals the risk-free rate and does not depend on investor preferences
nor on the asset’s expected growth rate.11 Using Itô’s lemma, the value of the sovereign debt
satisfies

1 2
(2) rD = C + rV DV + V 2 DV V
2

where DV and DV V are the first and second derivatives, respectively, of the sovereign debt
value D with respect to the asset value V . The solution to this differential equation is subject
to a number of conditions. First, when the asset value V (and thus the present value of fiscal
revenues) tends to infinity, the value of the sovereign debt tends to the value of a risk-free
debt. Second, when default occurs, the recovery rate on the debt service C is 1 . The
relevant boundary conditions are:

C C(1 )
(3) lim D(V ) = and lim D(V ) =
V !1 r V !V D r

The value of sovereign debt associated with the above boundary conditions is given by
(Appendix A)
11
From market completeness, there exists a riskless portfolio strategy that holds a traded asset (e.g., equity)
perfectly correlated (locally) with the firm’s asset value V , sovereign debt value D, and the risk-free asset.
Therefore, any security that is a function of asset value V must have the same (risk-free) expected return (see
Merton, 1973; Leland, 1994).

10
 "Z # Z
TD 1
Q Q
(4) D(V ) = E Ce rt
dt +E (1 )Ce rt
dt
0 TD
| {z } | {z }
Debt service before default Debt service after default
2 3
6 ✓ ◆ 7
C 6 V 7
(5) = 61 7
r 4 VD 5
| {z }
Default premium

where Q denotes the risk-neutral probability measure and is the negative root of the
quadratic equation 1
2
2
( 1) + r r = 0, which is given by

2r
(6) = 2
<0

The market value of sovereign debt D(V ) is equal to a riskless perpetual debt with con-
tinuous coupon C minus a default premium. This premium corresponds to the present value
of the unrecovered value of the debt after default, where the Arrow-Debreu price of default
h i
EQ e rT = VVD has the interpretation of the present value of $1 conditional on future
D

default (i.e., V falling to V D ). Lenders anticipate the government’s opportunistic behavior

by reflecting the associated wealth extraction in the pricing of sovereign debt.

C Sovereign Wealth

The government’s objective is to maximize sovereign wealth, which is defined as the present
value of future fiscal revenues and public investment returns, net of future debt payments.

11
Sovereign wealth W (V ) is given by

Z 1
Q rg
(7) W (V ) = ⌧V E Ce rt dt + D(V )
0 r
| {z }
| {z }
Discounted fiscal revenues net of debt service Debt issuance benefits
Z 1 h i
Q Q rT D
+E C e dt rt
E ⌧ VT D e
| TD
{z } | {z }
Default gain Default costs
✓ ◆ rg
" ✓ ◆ #
V 1 C V
(8) = ⌧V ⌧V D + r 1
VD r VD

The first term on the right-hand side of Equation 7 is the present value of future fiscal
revenues net of debt payments in the absence of default. The second term captures the
incentives for issuing debt. The last two terms represent the reduction in debt service and
the economic costs of default multiplied by the Arrow-Debreu price of this event.
Sovereign debt issuance affects wealth in two ways. On one hand, it generates economic
value, thereby providing the government the incentive to issue sovereign debt. On the other
hand, more debt raises the risk that the government will be unable to service its debt in the
future. This risk matters to sovereign wealth because default reduces future fiscal revenues.
The government’s problem consists in solving for the optimal level of debt subject to the
default policy. Solving the model backwards, I first determine the optimal default policy for
a given level of debt, and then solve for the optimal level of debt.

D Default Policy

The default policy, characterized by the default boundary V D , is chosen to maximize sovereign
@W (V )
wealth W (V ), such that the smooth-pasting condition @V
|V =V D = ⌧ (1 ) is satisfied
(Appendix B):12
12
The smooth-pasting condition ensures continuity in both sovereign wealth and the stock market price, at
@W (V )|V =V D
the time of default (see Merton, 1973; Dumas, 1991). The condition satisfies @W@V(V ) |V =V D = @V .

12
 C rrg 1
(9) V D⇤ =
⌧ r (1 )

The debt reduction upon restructuring C provides the government the incentive to de-
fault. At the same time, the expected economic costs of default also rise with the willingness
to default. The government considers this trade-off when determining its default policy.
The government chooses a lower default boundary with greater default costs , public
investment returns rg , economic risk , corporate tax rate ⌧ , and the risk-free interest rate
r. Finally, the asset value V D at which the government chooses to default is proportional to
the debt coupon C and the debt reduction in default .
Figure 1 provides a sensitivity analysis of the optimal default policy with respect to the
model parameters. The baseline calibration of the model is as follows. The risk-free rate
is set to r = 4%, the tax rate to ⌧ = 30%, the contraction in asset value in default is set
to = 5%, the debt haircut in default is = 60%, and the return on public investment is
rg = 1%. Finally, the growth rate and the volatility of the firm’s assets are µ = 1% and
= 35%, respectively. The choice of parameter values is discussed in Section V.

Figure 1 [about here]

E Debt Policy

The optimal level of sovereign debt arises from the trade-off between the economic benefits
rg
of issuing one unit of debt r
and the costs of default . While the default boundary is
selected once debt has been issued to maximize sovereign wealth W (V ), the optimal level of
indebtedness is jointly determined by the government and the debtholders at time t = 0. The
chosen level of debt service C maximizes sovereign wealth W (V ) after debt has been issued

13
plus the value of debt D(V ), which is given by (Appendix C)

(10) C ⇤ = arg max W (V ) + D(V ) |t=0

C2R+
✓ ◆1/
⌧ V0 r (1 ) (rg r)
(11) = rg
r
1 rg

where V0 is the asset value at t = 0, at the time the debt policy is determined.
The level of debt is proportional to the asset value V0 and to the tax rate ⌧ . Both measures
translate into greater fiscal revenues, thus raising the optimal amount of borrowing. The
government also chooses to increase its level of debt with greater public investment returns
rg . The effect of economic risk and the risk-free interest rate r is non-monotonic and follows
a U-shape. In addition, government indebtedness increases with the expected default costs
because greater costs of default lower the incentive to default (i.e., through a decrease in
the default boundary V D ). A similar reasoning applies to the expected debt reduction upon
default , which lowers the optimal debt level. Figure 1 illustrates the determinants of the
optimal debt coupon in detail.
The model also generates predictions on the default probability and the level of indebt-
edness (Appendix D). The theoretical counterpart of the debt-to-GDP ratio is given by
D/V (r µ), which represents the market debt value divided by current income. Under
the baseline calibration, the indebtedness ratio is equal to 62.2% and the 5-year probability of
default is 8.65%. A sensitivity analysis is presented in Figure 2. Overall, the model generates
debt-to-GDP ratios and default probabilities that are comparable to those typically observed
in emerging and developed countries.13

Figure 2 [about here]

13
Moody’s (2011) reports a 5-year cumulative default probability of 7.43% for Ba sovereign issuers over the
period 1983-2010. Using data for all countries available on the World Bank’s website, the average debt-to-GDP
ratio over the period 1990-2010 is 57%.

14
F Asset Prices

The optimal default and debt policies determine the risk of a sovereign default, which can be
used for the valuation of asset prices in the economy.

F.1 Sovereign credit spread

The sovereign credit spread CS(V ), which measures the market’s perception of default risk,
is defined as (Appendix E)

2 3
C 6 1 7
(12) CS(V ) ⌘ r = r4 ⇣ ⌘ 15
D(V ) rg V
1 rg r V0

under the optimal default and debt policies V D⇤ and C ⇤ , derived in Equations 9 and 11,
respectively.
The determinants of sovereign credit risk are consistent with what is expected (see Figure
3). The credit spread increases with the incentives for government indebtedness rg and
with macroeconomic risk , but decreases with the risk-free interest rate r. At the optimal
indebtedness level, the sovereign credit spread is insensitive to several variables, including the
expected debt reduction upon default, the magnitude of the economic costs upon default,
and the tax rate ⌧ . The intuition is that the government optimally adjusts its debt policy to
those parameters to offset their effect on sovereign credit risk.14

Figure 3 [about here]

14
For example, increased default costs might be thought to reduce a government’s incentive to default and
thus to lower the sovereign yield spread. Indeed they do, but only for a given level of sovereign debt. As default
costs rise, the optimal level of debt increases, thus offsetting the initial effect on the default boundary. Similar
reasoning applies to other variables.

15
F.2 Stock price

The value of equity in the economy S(V ) is determined as the present value of firm income
after taxes, which is equal to (Appendix F)

h i
(13) S(V ) = (1 ⌧ )V EQ (1 ⌧ )VT D e rT D
| {z } | {z }
Equity value without default
Expected loss in default
 1/ 1 ✓ ◆
(rg r) V
(14) = (1 ⌧ )V (1 ⌧ )V0
rg V0
| {z }
Sovereign default risk discount

h i
Q rT D
where Equation 14 obtains from the equality E VT D e =VD V
VD
, using the optimal
default and debt policies V D⇤ and C ⇤ , respectively.
The model suggests that the stock price depends negatively on the risk of sovereign
default, in line with Andrade (2009). Moreover, the sovereign default risk discount is coun-
tercyclical and thus magnifies the fall in stock prices in periods of economic downturn.
The model parameters affect stock market valuation with an intuitive sign, as illustrated
in Figure 3. The value of the stock market is low when investors expect severe economic
costs upon default (i.e., high ). In addition, stock market prices are high when the risk-free
rate r is high, the tax rate ⌧ is low, the level of economic risk is low, and when the incentive
for government indebtedness rg is low. Finally, the price of equity is high when the expected
debt reduction in default is large (i.e., high ), which is associated with a low optimal debt
level (i.e., low default probability).

16
IV Data

The following sections bring the pricing model to the data and examine its ability to explain
the dynamics of sovereign credit risk. The approach consists of using the model to generate
daily credit spreads that are compared to the observed sovereign bond spreads.

A Sample

The sample consists of European and emerging countries over the period January 3, 2000 -
December 30, 2011. The European countries under analysis are those that have attracted
the greatest attention over recent years because of their strong variation in sovereign credit
risk, namely, France, Greece, Ireland, Italy, Portugal, and Spain.15 For comparison, I consider
large government debt issuers from emerging markets, including Brazil, Colombia, Mexico,
Peru, Russia, and Turkey. Overall, these 12 countries have issued a total value of $8,550
billion in principal in 2010. They also present different geopolitical characteristics and levels
of credit risk.

B Sovereign Credit Spreads

The benchmark credit spreads for emerging countries are the Emerging Markets Bond Index
(EMBI+) spreads computed by JP Morgan.16 These spreads track the required returns of
government debt instruments in emerging countries in excess of the return of a U.S. Treasury
bond of equal maturity. For European countries, I compute the daily spreads as the difference
in yield-to-maturity between a country’s 10-year government bond and an identical German
15
I do not consider countries that exclusively issue government debt in their respective currency (e.g., Norway,
the UK, and Switzerland). Subtracting a risk-free yield of the same currency is impossible, since a corresponding
riskless bond does not exist. In addition, default is unlikely in such countries because of the possibility of
monetizing debt.
16
JP Morgan, one of the major dealers in the Brady market, derives the credit spread implied in the price
of each Brady bond. The company computes each country’s EMBI+ index, which is a weighted average index
of spreads using the country’s most liquid Brady bonds. The data only consider external debt denominated in
U.S. dollars.

17
government bond.17 Credit spreads are in U.S. dollars for emerging countries and in euro for
European countries.
These spreads capture the risk premium that investors demand for bearing sovereign
default risk above that implied by a riskless asset, thus appropriately reflecting a country’s
creditworthiness. Liquidity risk is thus explicitly ignored in this paper. Bond data are preferred
to sovereign credit default swap spreads, which present infrequent quotes (due to low issuance
and trading activity) on a daily basis over the sample period. The data in this study come
from Datastream.

C Descriptive Statistics

Table 1 displays the first two moments of the daily sovereign credit spreads for emerging
markets and European countries. It also provides the average statistics before and during the
European debt crisis that covers the period 2010-2011. The data show a substantial variation
in spreads over time and across countries. The average pre-crisis sovereign spread is 29 basis
points in Europe, while it is 400 basis points in emerging economies.18 During the 2010-2011
crisis, the average sovereign spread rises to 430 basis points in Europe, while it decreases to
195 basis points in emerging economies. The average volatility in sovereign spreads is 5.3%
and 38.6%, respectively, before the crisis, while it is 41.5% and 5.7%, respectively, during
the European crisis. Sovereign credit risk has thus recently shifted from emerging markets to
Euro area member states.

Table 1 [about here]

17
An alternative is to use the difference between the JP Morgan Global Bond Index (GBI) yield-to-maturity
of a country and a maturity-matched German government bond yield-to-maturity. Such an approach is less
straightforward because it requires a linear interpolation to obtain the yield of a German government bond proxy
with an average maturity that matches the average maturity of a country’s Global Bond Index. This estimation
needs to be repeated every day, as the average maturity of a Government Bond Index (i.e., the average life)
varies continuously. Though more complicated, this approach generates very similar results.
18
Spreads in Europe and in emerging markets are not directly comparable, as they are not denominated in
the same currency. The difference in the level of credit risk is nevertheless too substantial to be attributed to
a currency effect.

18
V Estimation

This section presents the estimation of the model, the calibration, and the estimation output.

A Approach

The empirical strategy consists in estimating the model parameters, which are then used
to generate model-implied sovereign credit spreads. The importance of avoiding an over-
identification problem puts restrictions on the set of parameters to estimate. I focus on the
key parameters of the model that are unobservable and calibrate the remaining ones (see
Section V.D). The parameters I estimate, for each country, are the growth rate µ and the
volatility of asset value V and the return on public investment rg , which captures the
government’s incentives for indebtedness.
The approach follows a two-stage maximum-likelihood estimation procedure. The first
stage relates to the estimation of the dynamics of the unobservable asset value (µ, , and
V ). The second stage estimates the government’s benefits of issuing debt, captured by the
return on public investment (rg ). The two-stage estimation is repeated by iteration until
convergence of the parameter values. These final estimates, combined with the time-series
of asset value V , allow us to generate daily model-implied credit spreads for each country.
Two reasons motivate the choice of an estimation in two steps. First, a joint estimation
of these parameters would raise an identification concern, since rg and influence stock
prices in a similar fashion (see Figure 3). Second, these parameters are best estimated from
different sources of information, which are the local stock market for the dynamics of the
asset value and the sovereign credit market for the government’s incentives for indebtedness.
The following sections analyze the estimation in greater detail.

19
B Asset Value

The structural model shows that all securities of a country can be seen as contingent claims
on asset value. It is thus possible to use price information for one class of securities (i.e., local
stock market) to infer the value of another (i.e., sovereign debt). The unobservable asset
value can be obtained from observable stock market prices by maximum-likelihood estimation,
given the one-to-one correspondence between asset value V and stock prices S(V ). The first
stage of the estimation thus consists of determining jointly the time-series of the asset value
V , its growth rate µ, and its volatility . The parameter µ is estimated, though it is not used
for the pricing of securities. The approach follows the methodology developed by Duan (1994)
and Ericsson and Reneby (2005) for derivative securities and corporate assets. Appendix B.1
provides the derivation of the likelihood to maximize.
Stock market prices in this paper are given by the Morgan Stanley Capital International
(MSCI) local stock market index for each country. Values are in U.S. dollars for emerging
countries and in euro for European countries.

B.1 Estimation with market prices vs. conventional approach

The traditional approach to generating model credit spreads has been to use economic indi-
cators such as consumption, output, or government fiscal revenues. However, such data are
observable at low frequency (i.e., quarterly or annually) and contain past information. The
consideration of this type of data is thus not particularly appropriate to generate sovereign
credit spreads, which are forward-looking measures observed at a high frequency.
In this paper, I suggest using the forward-looking information embedded in daily local
stock market prices. An advantage of this approach is that it is not restricted to a particular
frequency of data. Moreover, local stock market prices seem to provide relevant information
for the pricing of sovereign credit risk. Figures 4 and 5 demonstrate a strong relationship
between local stock market prices and sovereign credit spreads, both in emerging and in
European countries. Specifically, sovereign credit spreads rise when the economy performs

20
poorly, as observed with a fall in local stock prices.

Figures 4 and 5 [about here]

C Incentive for Indebtedeness

In a second stage, I estimate the level of return on public investment rg , which captures the
government’s incentives for indebtedness within the model. This parameter determines the
relationship between a country’s asset value and its sovereign credit spread, and thus the
sensitivity of credit risk to changes in economic conditions.
Government indebtedness is a key driver of the sovereign credit market. A country with
greater incentives for issuing debt tends be more indebted, thus raising the likelihood of
sovereign default. In comparison, this information plays only a secondary role in the valuation
of stock market prices. The use of credit market prices is thus preferable to obtain an estimate
of rg that generates reasonable levels of credit risk. I therefore determine this parameter by a
maximum-likelihood estimation of sovereign spread data. The likelihood is derived in Appendix
B.2.

D Calibration

I now discuss the calibration of the remaining parameters. In line with the model’s assumption
of constant parameters, the parameter values are fixed over the sample period.19
The relevant risk-free rate r for emerging countries is the average 10-year U.S. Treasury
rate, which is equal to 4.46%. The risk-free rate in Europe is the average 10-year yield on
German government bonds, which is equal to 3.52%. The risk-free rate is thus the same
across countries with securities measured in the same currency. The expected loss to
debtholders upon default is set to 60% for European countries and 75% for emerging coun-
19
The advantage of having constant parameters is that the endogenous default boundary can be derived
analytically. Section VI.D.5 discusses the limits and possible extensions of the model.

21
tries. It is a market convention for the quotation of sovereign credit default swap contracts
to use such values, which are identical within groups of emerging and developed countries.20
Finally, the expected economic contraction in sovereign default is taken from Andrade
and Chhaochharia (2011), who infer the expected costs of sovereign default from local stock
market prices. Their estimate equals, on average, 4.1% and 5% for emerging economies
and European countries, respectively. Similarly, Mendoza and Yue (2012) find that sovereign
defaults are associated with a fall in GDP of 5% on average, using data from 23 default
events over the period 1977-2009. I consider the same estimate within a group of countries,
though the expected economic costs of sovereign default is likely to be heterogeneous across
countries. The reason for this choice is that the results presented in this paper are not driven
by this parameter. As illustrated in Figure 3, this parameter has a negligible effect on the
valuation of stock prices and credit spreads under optimal debt and default policies.

E Estimation Output

E.1 Parameter estimates

Table 2 reports the parameter estimates. Asset value uncertainty is, on average, 35.4%
for emerging markets (Panel A) and 23.1% for European countries (Panel B). The difference
in estimates across both groups appears to be in line with the view that European countries
present lower economic uncertainty than emerging countries.21 The estimated rate of return
on public investment rg is, on average, 2.52% in emerging countries (Panel A) and 0.26% in
Europe (Panel B). Emerging economies thus offer enhanced investment opportunities com-
pared to European countries. All coefficient estimates are highly statistically different from
zero (p-values < 0.1%).

Table 2 [about here]

20
See ISDA’s standard CDS contract specifications (http://www.cdsmodel.com/cdsmodel/documentation.page?#).
21
For transparency, Table 2 also reports the estimates of the asset value growth rate µ, which are positive
for emerging countries (Panel A) and negative for European states (Panel B). The statistical significance of
these estimates is not discussed, as this parameter is not used to price securities.

22
E.2 Estimated asset value

Figures 6 and 7 plot the estimated asset value for emerging and European countries, re-
spectively. The evolution of each country’s asset value V is compared to the level of its
endogenous default threshold, V D . We can see that, most of the time, countries are far from
their optimal default threshold, thus indicating a low sovereign credit risk level. However, the
plots also demonstrate that most countries were close to (or at) default at least once over
the 2000-2011 period. In particular, the analysis suggests that Colombia, Peru, and Russia
were on the brink of default in 2001, at the time of the Argentinean crisis. Brazil and Turkey
were also close to defaulting a couple of years later, in 2003. Among European countries,
Portugal and Greece had a peak in the likelihood that they would be unable to repay their
debt in 2003, well before the recent European debt crisis. Italy and Portugal were close to
distress both in 2009 and at the end of 2011, while Ireland stayed close to default over the
2009-2011 period. Finally, the model indicates that Greece has clearly entered the default
territory mid-2011.

Figures 6 and 7 [about here]

VI Results

This section uses each country’s parameter estimates and its asset value inferred from local
stock market prices to generate daily sovereign credit spreads.

A Overview

I first discuss the model pricing errors and analyze the model’s ability to replicate the overall
dynamics of sovereign credit spreads in emerging and European countries.

23
A.1 Pricing errors

The estimation of the model matches each country’s level and volatility of sovereign spreads
relatively well, despite the strong heterogeneity in sovereign spreads across countries and
economic conditions. The average pricing errors from Table 1 are small: 7 basis points in
Europe and 62 basis points in emerging markets. Table 2 reports a low root mean square
error (RMSE), with an average of 169.5 and 111.4 basis points for emerging (Panel A) and
European (Panel B) countries, respectively.

A.2 Time-series of sovereign credit spreads

This section compares the daily dynamics of the model-implied credit spreads with the ob-
served credit spreads. Figures 8 and 9 illustrate the average spreads for emerging and Eu-
ropean countries, respectively. The model credit spreads and the observed EMBI+ spreads
evolve very similarly over both quiet and turbulent periods; the model captures the eco-
nomic downturn in 2001-2003 in emerging markets, the substantial and steady narrowing of
sovereign spreads over 2004-2007, and the peak in spreads after the failure of Lehman Broth-
ers in September 2008. The weak U.S. economy triggered a global fall in economic activity
at the end of 2008 and early 2009, which has been accompanied by a rise in sovereign credit
risk. The model also reproduces the subsequent decline in spreads helped by a period of rapid
economic recovery in emerging economies in 2010, as well as the recent rise in sovereign
credit risk related to the fear of widespread European defaults in 2011.

Figures 8 and 9 [about here]

Turning our attention to Europe, the model replicates the overall narrow spreads over the
period 2000-2008, as well as the rapid rise in sovereign default risk that followed the U.S.
financial turmoil in 2008-2009. The model credit spreads also appear to replicate the sharp
increase in credit risk during the European debt crisis, particularly for Greece and Italy in the
second half of 2011.

24
 The model suggests a rise in European default risk in 2002-2004, when economic con-
ditions deteriorated sharply (see Figure 7). It is surprising to see that the credit market did
not react to such negative news. Moreover, yields broadly fell during this economic down-
turn, thereby indicating that European government bonds clearly benefited from a safe-haven
status before 2008. Sovereign default risk in Europe was essentially ignored at that time.

B Model Performance

In this section, I investigate the model’s ability to explain the dynamics of observed sovereign
spreads with a panel data analysis.

B.1 Econometric specification

This paper’s empirical strategy is to analyze credit spread levels, rather than credit spread
changes. In line with a recent strand of studies,22 this specification is preferable at daily
frequencies for several reasons. First, credit spreads are ex ante expected return differentials
and are thus expected to be stationary. Second, credit spreads are not characterized by long-
term stochastic trends. Third, first differentiating a stationary time-series and regressing
changes rather than levels introduces noise into the estimation. Such inefficiency tends to be
acute for daily spread data.23
To test the relation between observed and model credit spreads, I use the following model:

obs cs
(15) CSi,t = 0 + CSi,t + Controlst + "i,t

The analysis is based on a panel data estimation with country fixed effects, which combines
22
Existing studies on bonds spreads relying on regression in levels include Campbell and Taksler (2003),
Cremers, Driessen, Maenhout, and Weibaum (2008), Zhang, Zhou, and Zhu (2009), Ericsson, Jacobs, and
Oviedo (2009), and Doshi, Ericsson, Jacobs, and Turnbull (2011).
23
As discussed in Doshi et al. (2011), the choice between levels and difference regressions for credit spread
analysis is a complex one, and no consensus has thus far emerged in the literature. Nevertheless, the choice of
levels versus differences should depend on the frequency of the data. For monthly data, differentiating the data
may be the best choice, whereas for daily spread data, analyzing levels may be preferable.

25
the cross-country and the temporal dimensions in a single regression. The estimation is
run for emerging and European countries separately. The regression coefficients thus allow
for heterogeneous relations across types of countries. The vector Controls includes global
factors that capture other direct and indirect sources that may correlate with sovereign
spreads. These variables control for aggregate uncertainty, funding liquidity, and expectations
of future economic activity, as discussed in Section VI.C. Finally, standard errors are corrected
for heteroskedasticity with Newey and West’s non-parametric variance covariance estimator.
Results are reported in Tables 3 and 4.

Tables 3 and 4 [about here]

B.2 Main results

Tables 3 and 4 present the main empirical findings. Column 1 in each table displays a positive
relation between a country’s observed sovereign spread and the credit spread implied by the
model, both for emerging ( cs
= 0.855) and European ( cs
= 1.118) countries. The relation
is highly significant (t-statistics of 11.7 and 122.8, respectively). In addition, the explanatory
power of the model is substantial; it explains 66.1% and 69.2% of the total variation in
sovereign spreads for emerging and European countries, respectively.
These results show that the model-implied credit spreads, using information extracted
from the local stock market, are successful in explaining the dynamics in sovereign credit
spreads.

C Consideration of Additional Factors

The model explains a large fraction of the time variation in sovereign credit spreads. Yet it
does not explain all variation. Remolona et al. (2008) and Longstaff et al. (2011) suggest
that variations in sovereign credit risk can be largely attributed to changes in common factors
across countries. They consider a number of measures from the equity and fixed income

26
markets that can affect global investors. Notably, the option-implied volatility index (VIX)
is found to be a key factor in the explanation of sovereign credit risk (see also Pan and
Singleton, 2008; Hilscher and Nosbusch, 2010).
It is important to examine whether the model credit spreads continue to explain the time
variation in sovereign spreads once additional market-wide factors are accounted for. The
factors I consider for the analysis are the VIX, measuring global market uncertainty; the short
rate (3-month) in the U.S., an indicator of global funding costs; and the U.S. Treasury yield
(10-year), which designates the level of the long-term risk-free rate. I also include the slope
of the yield curve, computed as the difference between the 30-year and the 3-month U.S.
Treasury rates, which is known to have predictive content for future economic activity (e.g.,
Estrella and Hardouvelis, 1991).

C.1 Marginal explanatory power

Tables 3 and 4 (Column 2) show that the model credit spreads hold their economic and
statistical significance when these market-wide factors are included in the analysis. The
adjusted R2 rises to 72.5% and 71.3% for emerging and European countries, respectively. I
discuss the sign and significance of these additional factors in Section VI.D.4.
It is insightful to focus on the amount of information that the model credit spreads capture
and to compare it with that of the market-wide factors. To do so, I define the “model ratio”
as the fraction of the total variation explained in Equation 15 that can be attributed to the
variation in model spreads alone; it is thus computed as the R2 from the regression that only
includes the model spreads (Column 1) divided by the adjusted R2 from the full regression
(Column 2). The “model ratio” equals 91.2% for emerging spreads and 97.1% for European
spreads. The model spreads capture most of the variation in market-wide factors, thus
suggesting that the local stock market is a useful aggregator of information for the pricing
of sovereign credit risk.24
24
The model credit spreads, being computed from local stock prices, contain a global component and are
thus not orthogonal to market-wide factors. The difference between one and these ratios provide lower bounds

27
C.2 Euro zone factors

A potential issue for European countries is the consideration of additional factors from dollar-
denominated asset prices to explain credit spreads denominated in euro, particularly in a time
period with large swings in the dollar/euro exchange rate. To deal with this concern, Table 5
provides the same analysis as in Table 4 but using global factors from the EuropeaC.n market.
I consider for this analysis the option-implied volatility on the EuroStoxx 50 index (VSTOXX)
and the German Bund yields to compute the levels and the slope of the term structure. The
analysis shows that the results remain very similar with such factors.

Table 5 [about here]

Overall, the structural model accounts for a single source of information but captures a
relatively important fraction of the time variation in sovereign credit spreads, in particular for
large sovereign debt issuers with liquid credit and equity markets. Two features of the model
explain the good performance. First is the consideration of local stock market prices as input,
which aggregate information on a country’s future economic conditions and on global market
sentiment. Second, the model accounts for a structural non-linear relation between stock
prices and sovereign spreads. The next section discusses these points in greater detail.

D Discussion

D.1 Local stock market and sovereign credit risk

The results of this paper demonstrate that the local stock market is a useful source of
information for the explanation of sovereign credit risk. That is, good news for the local
stock market is also good news for sovereign credit spreads.
of the proportion of the total variation due to these additional factors. The upper bounds are given by Column
3 of Tables 3 and 4, which indicate that the four factors explain up to 46.8% and 22.5% of the time variation
in observed spreads for emerging and European countries, respectively. Note that the explanatory power of
all factors combined is lower than that of the model-implied spreads, which amounts to 66.1% and 69.2%,
respectively.

28
 However, such information alone is not sufficient to explain the dynamics of sovereign
spreads. To see that, Tables 3 and 5 compare the explanation of the model credit spreads
with a specification that uses the local stock market index directly. When the local stock
market index replaces the model credit spreads in Equation 15 (Column 4), the adjusted R2
equals 28% and 15% in emerging and European countries, respectively. When other factors
are controlled for, the explanatory power rises to 52.9% and 28.1% (Column 5). However,
the relation between observed sovereign spreads and the local stock market becomes weakly
significant in emerging countries and insignificant in European countries. In contrast, the
model-implied spreads are a non-linear transformation of the local stock market index and
explain 66.1% and 69.2% of the time variation in sovereign spreads in emerging and European
countries, respectively (Column 1). In addition, the relations are highly significant.
This analysis highlights the importance of the non-linear relation between the local stock
market and sovereign credit risk. An alternative specification is then to consider the inverse
of the local stock market index. Columns 6 and 7 in Tables 3 and 5 report the results. As
expected, the explanatory power is improved: the adjusted R2 equals 52.3% and 63.7% in
emerging and European countries, respectively.25 Yet the same specification that instead
includes the model credit spreads remains clearly superior (see Column 2). The difference
in adjusted R2 is 13.8% (9.5%) in emerging markets and 5.5% (2.4%) in Europe without
(with) additional factors. All countries exhibit a non-linearity that is best captured by the
structural model.
Furthermore, the direct use of stock market information (i.e., without the model) raises
several issues, in addition to the lower performance. First, the absence of a model does not
offer the possibility of generating a measure of sovereign spread, which can then be compared
25
Longstaff et al. (2011) show that, while most countries exhibit a statistically significant effect of the local
stock market return on sovereign credit spreads, the contribution of the local stock market seems limited. They
find that the fraction of the total variation explained by the stock market index (in addition to other local
variables) is 43%. In the current study, the fraction is a bit higher and equals 53% for emerging and European
countries. However, this fraction rises to 83% and 92% when using the inverse of the local stock market index.
Therefore, the consideration of a linear relation between stock prices and sovereign credit risk may seriously
underestimate the information content of the local stock market for the explanation of sovereign spreads.

29
to the data. Second, stock market prices themselves depend on the level of sovereign credit
risk through the adverse consequences of sovereign default on the economy, thus raising a
concern of reverse causality. In contrast, the structural estimation of the model allows us to
explicity control for this issue.

D.2 Structural non-linearity

The highly non-linear structural relation between local stock market prices and sovereign
credit risk is key to the success of the model. To demonstrate that, Figure 10 displays the
empirical relationship between a country’s stock market performance and its level of sovereign
credit risk.26 The data suggest that the relationship greatly differs across countries. The
model estimated by maximum likelihood yields a theoretical relationship between a country’s
stock prices and sovereign spreads that closely fits the empirical non-linear relationship.

Figure 10 [about here]

As a result, the model is able to account for the underlying non-linear relationship between
stock market information and sovereign credit risk to price credit spreads that are linearly
comparable to observed sovereign spreads. This analysis highlights the importance of using
a structural approach for the modelling of sovereign credit risk.

D.3 Test of the model

It is insightful to test how the model-implied sovereign spreads compare to those in the data.
Under the null hypothesis, the point estimate of the constant should be equal to zero,
meaning that the model adequately matches the level of sovereign spreads, and the estimate
cs
should be equal to unity, indicating a perfect linear relationship. This test is based on the
analysis of Column 2 in Tables 3, 4, and 5.
26
For space considerations, I only provide figures for Brazil, Greece, Italy, and Russia, four countries that
differ substantially in terms of economic size, political risk, and industrial structure.

30
 European countries display a slope estimate that is very close to one and remarkably
similar across specifications. It is equal to 1.049 with the U.S. controls and to 1.035 with
the Euro zone factors. Moreover, we cannot reject that these estimates are equal to unity
(p-values equal 0.078 and 0.264, respectively). The constant is also not statistically different
from zero in both cases. For emerging countries, we can weakly reject the null hypothesis
that the slope estimate cs
is equal to unity (p-value=0.028). However, the constant is not
statistically different from zero.
Overall, the results of the tests show that the constant is not different from zero and the
model credit spread’s coefficient is close to one. It is noteworthy that, upon weak rejection,
the departure from the null hypothesis is economically small. The model credit spreads can
thus be viewed as being linearly related to their observed counterparts.

D.4 Residual variation analysis

The results have shown that sovereign credit risk responds to news contained in the local
stock market, as predicted by the model, but also to additional global factors. I now discuss
the significance and the sign of the relationships between these factors and the sovereign
credit spreads. The analysis is based on Column 2 of Tables 3, 4, and 5.
The data indicate that sensitivity to such factors differs considerably across emerging and
European economies. First, the level of option-implied volatitility in the U.S. (VIX) greatly
widens emerging spreads, while it has no impact on European sovereign credit risk, beyond
what the model already captures. European and emerging countries thus differ considerably
in their sensitivity to global market uncertainty. Similar results obtain with the option-implied
volatility on the EuroStoxx 50 index (VSTOXX), thus suggesting that the currency denomina-
tion and the geographic origin of the volatility measure are not the reasons for the discrepancy.
Factors related to the U.S. Treasury market do not provide additional information to the
explanation of European and emerging spreads. However, European sovereign spreads appear
sensitive to the information embedded in the Euro bond market. In particular, a steeper slope

31
of the German Bund term structure reduces the costs of debt in Euro member states (i.e.,
improved economic outlook) and a higher 10-year Bund yield is associated with an increase
in European spreads (i.e., greater costs of long-term financing). In addition, the effect of the
short rate (3-month) is not statistically significant, thereby suggesting that the recent rise in
European sovereign credit risk is more related to a solvency than to a funding liquidity crisis.
The variation in sovereign credit risk that is unexplained by the model, therefore, mostly
relates to financial market uncertainty in the U.S. for emerging markets and to expectations
embedded in the Euro bond market for European countries.

D.5 Time variation in model parameters

This section discusses the issue that the model parameters remain fixed over the sample
period, while they could be time varying and related to fluctuations in sovereign credit spreads.
First, the return on public investment rg is likely to vary over time, but its future variation
would not affect the model credit spreads under the current setting. This parameter matters
only at the initial date, when the government issues debt and instantly finances public invest-
ments at this rate of return. Variations in the return on public investment could, however,
play a role in a model with dynamic debt issues.
Second, it is reasonable to assume that the (unobservable) parameters and can be
viewed as independent from current economic conditions because changes in these parameter
estimates have no effect on the model credit spreads when governments can choose their
level of debt and the timing of default (see Figure 3). These parameters could, however,
affect the estimation of the model through their impact on stock market prices. To address
this concern, Table 6 illustrates the sensitivity of the estimation results to changes in the
calibrated values of the parameters and . The results show that the estimation is robust.
The parameter estimates remain stable and the model credit spreads fit the observed spreads
very similarly across changes in parameter values.
Finally, the risk-free rate and the volatility of asset value are the variables most likely

32
to change over time with a potential effect on the pricing of sovereign spreads. Therefore,
I include these measures in Table 7, in addition to the model-implied credit spreads, to
determine how their variation could help further explain the observed credit spreads. The
risk-free rate is given by the daily 10-year yield of U.S. Treasuries and German Bunds for
emerging and European countries, respectively. The volatility measure is computed as the
conditional volatility of each country’s estimated asset value growth rate using a GARCH(1,1)
model.

Tables 6 and 7 [about here]

The results indicate that the conditional asset volatility has a statistically significant effect,
but for emerging spreads only. In contrast, the time variation in risk-free rates does not seem
to contain useful information. This finding is in line with the sensitivity analysis provided
by Table 6, which shows that the fit of the model remains stable when changing the level
of the risk-free rate. The model developed in this paper thus seems to capture well the
dynamics of European credit spreads using stock market data as the only time-varying input.
Accounting for the time variation in a country’s asset volatility would, however, help better
explain emerging market spreads, which tend to be, on average, wider and more volatile.
Allowing volatility to be stochastic within a structural credit risk model is, however, technically
challenging.27
A class of models that may be worth exploring allow for the presence of Markov-switching
regimes. Building on the framework of Hackbarth, Miao, and Morellec (2006), recent studies
appear to be successful in explaining corporate credit spreads (Bhamra, Kuehn, and Strebulaev
2010; Chen 2010). Their results suggest that regime shifts in the level and the volatility in
the earning growth rate allow the generation of a countercyclical default boundary that raises
the probability of default, without necessarily increasing the level of debt. Compared to the
standard case (e.g., Leland, 1994), this approach helps to better explain the behavior of firm
27
The stochastic volatility process has not received much attention in structural credit modeling because of
the considerable technical difficulties involved, particulary when default is endogenous. The technical hurdle
arises when solving partial differential equations with an unknown boundary.

33
credit spreads. Extending sovereign credit risk models along this line is certainly an avenue
for future research.

VII Conclusion

This study develops and estimates a structural model for sovereign credit risk that endogenizes
government debt and default policies. The model is a novel and intuitive framework for the
analysis of country creditworthiness that provides a closed-form solution for the computation
of sovereign credit spreads. In addition, this paper provides evidence that the model helps
explain a large part of the dynamics of daily sovereign credit spreads in emerging markets and
European countries. The results are robust for different countries and hold both before and
during the recent European crisis. The model’s success relies on the capacity to structurally
extract a time-series of information from the local stock market, which is found to be a
central ingredient for the valuation of sovereign credit risk. This approach is not restricted
to a particular frequency of data and can thus be used by market participants to evaluate
sovereign credit risk with any kind of investment horizon.
This paper also shows that the sovereign bond market is sensitive to different market-
wide factors across emerging markets and Euro area countries; factors related to global
market uncertainty in the U.S. drive emerging spreads, whereas spreads in Europe depend on
expectations of future economic growth embedded in the European bond market. Overall,
the results of this paper help us understand why sovereign credit spreads exhibit considerable
daily variation, while economic data known to be determinants of sovereign credit risk are only
available quarterly or annually. Other dimensions are likely to play a role in the valuation of a
country’s creditworthiness, such as the political nature of the European debt crisis, the role
of imperfect information on a country’s fundamentals, or the fear of international contagion
in credit risk. While such an analysis is beyond the scope of this study, it certainly provides
an interesting agenda for future research.

34
Appendix

A Model

A.1 Sovereign debt

Under the assumption that a sovereign default occurs at time T D = inf{t 0 | Vt  V D },

when V falls to the default threshold V D , the value of sovereign debt is given by
"Z # Z
TD 1
Q Q
(16) D(V ) = E Ce rt
dt + E (1 )Ce rt
dt
0 TD
" ✓ ◆ #
C V
(17) = 1
r VD

with the Arrow-Debreu price of default equal to

h i ✓ ◆
Q rT D V
(18) E e =
VD

from Karatzas and Shreve (1991, p.197), and where is the negative root of the quadratic
equation 1
2
2
( 1) + r r = 0, given by

2r
(19) = 2
<0

A.2 Default policy

The first-order maximization of sovereign wealth W (V ) yields

✓ ◆ 1 rg ✓ ◆ 1
@W (V ) V C 1 V
(20) = ⌧ ⌧ r
@V VD rV D VD

@W (V )
Using the smooth-pasting condition @V
|V =V D = ⌧ (1 ), we have

rg
C 1
(21) ⌧ ⌧ r
= ⌧ (1 )
rV D

35
which yields

C rrg 1
(22) V D⇤ =
⌧ r (1 )

A.3 Debt policy

The optimal level of indebtedness is determined to maximize the sum W (V ) + D(V ), where

✓ ◆ " ✓ ◆ #
V rg C V
(23) W (V ) + D(V ) |V D =V D⇤ = ⌧ V ⌧ C' + 1
C' r2 C'

( rrg 1)
under the optimal default policy given by V D⇤ = C', with ' = ⌧ r (1 )
.
The first-order maximization yields

✓ " ◆ ✓ ◆ #
@W (V ) + D(V ) |V D =V D⇤ rg V V
(24) = ⌧' + 2 1
@C r C' C'
✓ ◆✓ ◆
rg V
+ '+ 2
r C'
(25) = 0

After simplification, we have

✓ ◆✓ ◆
rg V rg
(26) (1 ) ⌧' + 2 =
r C' r2

( rrg 1)
Replacing ' = ⌧ r (1 )
in the above equation yields

!
V ⌧ r (1 ) rg
(27) rg =
C r
1 (rg r)

Finally, the optimal debt coupon chosen at time t = 0 is given by the expression

✓ ◆1/
⇤ V0 ⌧ r (1 ) (rg r)
(28) C = rg
r
1 rg

36
and the default policy at optimal indebtedness is given by

✓ ◆1/
D⇤ C ⇤ rrg 1 (rg r)
(29) V = = V0
⌧ r (1 ) rg

A.4 Probability of sovereign default

The probability that the government defaults within a time period T is defined by

0 ⇣ ⌘ 1
✓ ◆ D⇤
ln( VV0 ) r
2
T
2
(30) P inf Vt  V D⇤ | V0 > V D⇤ = @ p A
0tT T
0 ⇣ ⌘ 1
✓ D⇤
◆ 2r2 1
D⇤
ln( VV0 ) + r
2
T
V @ 2
A
+ p
V0 T

where (·) is the cumulative density of a standard normal distribution. It represents the
probability that V falls to V D⇤ , starting at time t = 0, with a drift r for the process V .

A.5 Sovereign credit spread

The credit spread CS(V ) related to debt D(V ) is defined by

" ✓ ◆ # 1
C⇤ V
(31) CS(V ) ⌘ r=r 1 r
D(V, C ⇤ , V D⇤ ) V D⇤
2 3
6 1 7
(32) = r4 ⇣ ⌘ 15
rg V
1 rg r V0

where the second equality is obtained when the value of debt D(V ) is replaced by its expression
derived in Equation 17, under the optimal debt and default policies C ⇤ and V D⇤ .

37
A.6 Stock price

The stock price S(V ) in the economy is given by

h i
Q rT D
(33) S(V ) = (1 ⌧ )V E (1 ⌧ )V TD e
✓ ◆
V
(34) = (1 ⌧ )V (1 ⌧ )V D
VD

h i
where EQ VT D e rT D
=VD V
VD
from the strong Markov property for Brownian motion.
Under the government’s optimal default policy V D⇤ and indebtedness level C ⇤ , the stock
price is finally determined by

 1/ 1 ✓ ◆
(rg r) V
(35) S(V ) = (1 ⌧ )V (1 ⌧ )V0
rg V0

B Maximum-Likelihood Estimation

This section describes the estimation of the model. The approach follows a two-stage
maximum-likelihood estimation procedure. Appendix B.1 derives the first stage, which re-
lates to the estimation of the dynamics of the unobservable asset value ( and V ). Appendix
B.2 presents the second stage, which estimates the government’s benefits of issuing debt,
captured by the return on public investment (rg ). Finally, Appendix B.3 details the implemen-
tation of the estimation procedure to obtain the parameter estimates and the model-implied
credit spreads.

B.1 Asset value dynamics

The maximum likelihood estimation of the unobserved asset value V follows the approach
developed by Duan (1994) and Ericsson and Reneby (2005). The estimation is carried out
using a time-series of stock prices, S obs = Stobs : t = 1, ..., T , where t indexes daily obser-
vations. The stock prices capture the performance of a country’s stock market index net of

38
the risk-free rate.
The log-likelihood function of the observed price variable Sobs is given by

T
X
(36) L Sobs ; ✓ = lnf Stobs | Stobs1 ; ✓
t=2

where ✓ is a vector of parameters to be estimated and the density function for the stock price
is determined by

✓ ◆ 1
@St (Vt )
(37) f Stobs | Stobs1 ; ✓ = g (lnVt | lnVt 1 ; ✓) |Vt =V (S obs ;✓) ⇥ |
@lnVt Vt =V (St ;✓)
obs
t

using the density function for the log of the asset value:
!
1 (lnVt mt ) 2
(38) g (lnVt | lnVt 1 ; ✓) = p exp 2
2⇡ 2 t 2 t

with mt being the conditional first moment equal to

✓ ◆
1
(39) mt = E (lnVt | lnVt 1 ) = lnVt 1 + µ 2
t
2

The function transforming stock prices to asset values is defined as V Stobs ; ✓ = S 1

Stobs ; ✓ ,
which is the inverse of the stock price formula S(V ) derived in Equation 14.
Finally, the log-likelihood function of the vector Sobs for a given choice of ✓ is as follows:

T 
X @S(Vt )
(40) L S obs
;✓ = lng (lnVt | lnVt 1 ; ✓) |Vt =V (S obs ;✓) ln |
@lnVt Vt =V (St ;✓)
obs
t
t=2

The parameter vector, ✓ˆ = {µ̂, ˆ }, is estimated by maximizing Equation 40 with respect

to ✓. The asset value growth rate µ is estimated, although it is not relevant for pricing.
⇣ ⌘
The inverse stock price function V̂t = V Stobs ; ✓ˆ is used to obtain the time-series of the
estimated asset value. The estimated asset value and the volatility parameter are used to

39
generate the model credit spread, which is used in the second stage of the estimation:
" #
⇣ ⌘ 1 2r
(41) CSt V̂t = r rg
1 with =
1 rg r
V̂t ˆ2

B.2 Return on public investment

The second stage determines the parameter rg by a maximum-likelihood estimation of the

observed sovereign spreads. The approach assumes that the estimated model credit spreads
can explain the observed sovereign spreads, but with errors:

⇣ ⌘
(42) CStobs = CSt V̂t ; rg + "t with "t ⇠ N 0, 2
"

The log-likelihood function of the observed credit spread variable CSobs is given by

T
" ✓ ◆#
X 1 "2t
(43) L CSobs ; rg = ln p exp
t=1
2⇡ 2
"
2 "2

The estimated return on public investment, rbg , is obtained by maximizing Equation 43.

B.3 Empirical implementation

The model credit spreads are generated using the following estimation procedure, which is
run independently for each country.

1. Select starting values for the parameters to estimate. For the return on public
investment (rg ), start with plausible values, such as 1% for European countries and 3%
for emerging countries. For the mean (µ) and the volatility ( ) of the asset value’s
growth rate, consider the mean and the volatility of the local stock market index growth
rate. The estimation of the model is robust to changes in starting values.

2. Calibration of the remaining parameters. Calibrate the model using the values pre-
sented in Section V.D. The calibrated parameters consist of the risk-free rate r, the

40
 debt haircut , and the expected costs of default .

3. First stage of the maximum-likelihood estimation. Estimate the parameter vector

✓ˆ = {µ̂, ˆ } by maximizing Equation 40 with respect to ✓. The inverse stock price
⇣ ⌘
function V̂t = V Stobs ; ✓ˆ is obtained with standard numerical procedures (e.g., New-
ton–Raphson’s method).

4. Second stage of the maximum-likelihood estimation. Use the volatility estimate ˆ

and the implied time-series of asset value V̂t obtained from the first stage to generate
credit spreads for a given return on public investment rg . Estimate the parameter rbg by
maximizing Equation 43.

5. Iteration until convergence. Resume the two-stage estimation procedure using the
set of parameter estimates {µ̂, ˆ , rbg } as new starting values. Iterate until convergence
is achieved.

6. Generate output. The final parameter estimates (ˆ , rbg ) and the implied asset value
(V̂t ) are used for the computation of the final series of model credit spreads, CSt .

41
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 0.18 Sovereign debt coupon (left axis) 80 0.16 30

0.16 Default boundary (right axis) 70

Sovereign debt coupon, C

Sovereign debt coupon, C

29.5

Default boundary, VD

Default boundary, VD
0.14
0.14 60
29
0.12 50
0.12 28.5
0.1 40
28
0.08 30
0.1
0.06 20 27.5

0.04 10 0.08 27
0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.03 0.035 0.04 0.045 0.05 0.055 0.06
Economic costs of default, λ Risk−free rate, r

0.16 45 0.2 40
Sovereign debt coupon, C

Sovereign debt coupon, C

0.14 40
Default boundary, VD

Default boundary, VD
0.15
35
0.12 35
0.1
0.1 30 30

0.05
0.08 25

25
0.06 20 0
0.2 0.25 0.3 0.35 0.4 0 0.005 0.01 0.015
tax rate, τ Public investment return, rg

0.22 70 50

0.2 0.16
Sovereign debt coupon, C

Sovereign debt coupon, C

60 45
Default boundary, VD

Default boundary, VD
0.14
0.18
50 40
0.12
0.16
40 0.1 35
0.14
0.08
30 30
0.12
0.06
0.1 20 25
0.04

0.08 10 0.02 20
0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.5 0.6 0.7 0.8 0.9 1
Economic uncertainty, σ Debt reduction in default, φ

Figure 1: Optimal Default and Debt Policies. This figure illustrates how the model’s main parame-
ters determine the government’s optimal default and debt policies. The default boundary is computed
with a fixed coupon payment (C = 0.1). Unless otherwise specified, the model’s parameters are as
follows: V = V0 = 100, = 0.35, r = 0.04, ⌧ = 0.3, = 0.05, = 0.6, and rg = 0.01.

46
 100 110 0.25
Debt−to−output ratio (left axis)
Default probability (right axis) 100
0.25

Default probability, 5 year

Default probability, 5 year

0.2
80
Debt−to−output (%)

Debt−to−output (%)
90
0.2
80 0.15
60 0.15
70 0.1
0.1
60
40
0.05
0.05 50

20 0 40 0
0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.03 0.035 0.04 0.045 0.05 0.055 0.06
Economic costs of default, λ Risk−free rate, r

90 120 0.35

0.25 100 0.3

Default probability, 5 year

Default probability, 5 year

80
Debt−to−output (%)

Debt−to−output (%)
0.25
0.2 80
70 0.2
0.15 60
60 0.15
0.1 40
0.1
50
0.05 20 0.05

40 0 0 0
0.2 0.25 0.3 0.35 0.4 0 0.005 0.01 0.015
tax rate, τ Public investment return, rg

100 0.35 100 0.2

0.3
Default probability, 5 year

Default probability, 5 year

90 80
0.15
Debt−to−output (%)

Debt−to−output (%)

0.25
80 0.2 60
0.1
70 0.15 40
0.1
0.05
60 20
0.05

50 0 0 0
0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.5 0.6 0.7 0.8 0.9 1
Economic uncertainty, σ Debt reduction in default, φ

Figure 2: Sovereign Debt-to-Output Ratio and Default Probability. This figure illustrates how
the model’s main parameters affect the debt-to-output ratio, D/V (r µ), and the 5-year default
probability. Unless otherwise specified, the model’s parameters are as follows: V = V0 = 100,
= 0.35, r = 0.04, µ = 0.01, ⌧ = 0.3, = 0.05, = 0.6, and rg = 0.01.

47
 300 70 220 70
Sovereign credit spread (left axis)
Sovereign credit spread (bps), CS

Sovereign credit spread (bps), CS

Stock market price (right axis) 69.8
250 200

Stock market price, S

Stock market price, S

69.8
69.6
200 180
69.4
150 69.6 160
69.2
100 140
69
69.4
50 120 68.8

0 69.2 100 68.6

0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.03 0.035 0.04 0.045 0.05 0.055 0.06
Economic costs of default, λ Risk−free rate, r

300 80 250 70
Sovereign credit spread (bps), CS

Sovereign credit spread (bps), CS

250
75 200 69.8
Stock market price, S

Stock market price, S

200
70 150 69.6
150
65 100 69.4
100

60 50 69.2
50

0 55 0 69
0.2 0.25 0.3 0.35 0.4 0 0.005 0.01 0.015
tax rate, τ Public investment return, rg

350 70 300 70
Sovereign credit spread (bps), CS

Sovereign credit spread (bps), CS

300 250
69.8
Stock market price, S

Stock market price, S

69.8
250
200
200 69.6
150 69.6
150 69.4
100
100
69.4
69.2
50 50

0 69 0 69.2
0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.5 0.6 0.7 0.8 0.9 1
Economic uncertainty, σ Debt reduction in default, φ

Figure 3: Sovereign Credit Spread and Stock Market Price. This figure illustrates how the model’s
main parameters affect sovereign credit risk and the valuation of the stock market. The sovereign
credit spread is given by Equation 12 and the stock market price by Equation 14. Unless otherwise
specified, the model’s parameters are as follows: V = V0 = 100, = 0.35, r = 0.04, ⌧ = 0.3,
= 0.05, = 0.6, and rg = 0.01.

48
 Brazil Colombia
6 25 18 12
Local stock market (left axis)
Sovereign spread (right axis) 16
5 10

Observed sovereign spread (%)

Observed sovereign spread (%)

20 14
Local stock market index

Local stock market index

4 12 8
15
10
3 6
8
10
2 6 4

5 4
1 2
2

0 0 0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Mexico Peru
4 6 12 9

8
3.5
5 10
Observed sovereign spread (%)

Observed sovereign spread (%)

7
Local stock market index

Local stock market index

3
4 8 6

2.5 5
3 6
2 4

2 4 3
1.5
2
1 2
1
1

0.5 0 0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Russia Turkey
8 30 1.8 12

7 1.6
25 10
Observed sovereign spread (%)

Observed sovereign spread (%)

1.4
6
Local stock market index

Local stock market index

20 1.2 8
5
1
4 15 6
0.8
3
10 0.6 4
2
0.4
5 2
1 0.2

0 0 0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Figure 4: Local Stock Market Performance and Sovereign Credit Spreads - Emerging Countries.
The figure plots the dynamics of daily observed spreads and the local stock market over the period
2000-2011. The sovereign spreads consist of the JP Morgan Emerging Market Bond Index (EMBI+)
spreads, while the stock market prices are given by the local Morgan Stanley Capital International
(MSCI) indices normalized to unity in 2000.

49
 France Greece
1.3 2 1 40
Local stock market (left axis)
1.2 Sovereign spread (right axis) 1.8 0.9
35

Observed sovereign spread (%)

Observed sovereign spread (%)

1.1 1.6 0.8
30
Local stock market index

Local stock market index

1.4 0.7
1
25
1.2 0.6
0.9
1 0.5 20
0.8
0.8 0.4
15
0.7
0.6 0.3
10
0.6 0.4 0.2
0.5 5
0.2 0.1

0.4 0 0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Ireland Italy
1.4 12 1.3 6

1.2
1.2
10 5
Observed sovereign spread (%)

Observed sovereign spread (%)

1.1
Local stock market index

Local stock market index

1 1
8 4
0.9
0.8
6 0.8 3
0.6
0.7
4 2
0.4 0.6

0.5
2 1
0.2
0.4

0 0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Portugal Spain
1.3 12 1.5 5

1.2 1.4 4.5

10
Observed sovereign spread (%)

Observed sovereign spread (%)

1.1 1.3 4
Local stock market index

Local stock market index

1.2 3.5
1 8
1.1 3
0.9
6 1 2.5
0.8
0.9 2
0.7 4
0.8 1.5
0.6 0.7 1
2
0.5 0.6 0.5

0.4 0 0.5 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Figure 5: Local Stock Market Performance and Sovereign Credit Spreads - European Coun-
tries. The figure plots the dynamics of daily observed spreads and the local stock market over the
period 2000-2011. The sovereign spreads are computed as the difference between each country’s and
Germany’s 10-year government bond yield-to-maturity, while the stock market prices are given by the
local Morgan Stanley Capital International (MSCI) indices normalized to unity in 2000.

50
 Brazil Colombia

3.5
10
Estimated asset value, V
Asset value and default threshold

Asset value and default threshold

3 D
9
Optimal default threshold, V
Default region 8
2.5
7

2 6
5
1.5
4

1 3
2
0.5
1
0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Mexico Peru
2.5

6
Asset value and default threshold

Asset value and default threshold

2
5

1.5 4

3
1

0.5
1

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Russia Turkey
1.2
4.5
Asset value and default threshold

Asset value and default threshold

4 1

3.5
0.8
3

2.5 0.6
2

1.5 0.4

1
0.2
0.5

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Figure 6: Estimated Asset Value and Optimal Default Threshold - Emerging Countries. The
figure plots the evolution of estimated asset values in emerging countries over the period 2000-2011.
The figure also displays the optimal default threshold and the corresponding default region for each
country. The asset value is estimated by maximum likelihood from local stock market prices (see
Section V), while the default threshold is determined by Equation 9 with the estimated parameter
values presented in Table 2 and the calibrated parameter values described in Section V.D.

51
 France Greece

Estimated asset value, V 0.9

1
Asset value and default threshold

Asset value and default threshold

D
Optimal default threshold, V 0.8
Default region
0.8 0.7

0.6
0.6 0.5

0.4
0.4
0.3

0.2
0.2
0.1

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Ireland Italy

0.9 1
Asset value and default threshold

0.8 Asset value and default threshold

0.7 0.8

0.6
0.6
0.5

0.4
0.4
0.3

0.2 0.2
0.1

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Portugal Spain

1
1
Asset value and default threshold

Asset value and default threshold

0.9
0.8
0.8
0.7
0.6
0.6
0.5
0.4
0.4
0.3

0.2 0.2
0.1
0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Figure 7: Estimated Asset Value and Optimal Default Threshold - European Countries. The
figure plots the evolution of asset values in European countries over the period 2000-2011. The figure
also displays the optimal default threshold and the corresponding default region for each country. The
asset value is estimated by maximum likelihood from local stock market prices (see Section V), while
the default threshold is determined by Equation 9 with the estimated parameter values presented in
Table 2 and the calibrated parameter values described in Section V.D.

52
 Brazil Colombia
35 12

30 Model credit spread

10
Observed credit spread
Sovereign credit spreads (%)

Sovereign credit spreads (%)

25
8

20
6
15

4
10

2
5

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Mexico Peru
6 12

5 10
Sovereign credit spreads (%)

Sovereign credit spreads (%)

4 8

3 6

2 4

1 2

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Russia Turkey
30 12

25 10
Sovereign credit spreads (%)

Sovereign credit spreads (%)

20 8

15 6

10 4

5 2

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Figure 8: Observed and Model Sovereign Credit Spreads - Emerging Countries. The figure
compares the model credit spreads and observed spreads for emerging countries over the period 2000-
2011. The model credit spreads are computed using the asset value estimated by maximum likelihood
from local stock market prices (see Section V), the estimated parameter values presented in Table 2,
and the calibrated parameter values described in Section V.D. The emerging sovereign spreads consist
of the JP Morgan Emerging Market Bond Index (EMBI+) spreads in U.S. dollars.

53
 France Greece
2 60

1.8 Model credit spread

Observed credit spread 50
1.6
Sovereign credit spreads (%)

Sovereign credit spreads (%)

1.4
40
1.2

1 30

0.8
20
0.6

0.4
10
0.2

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Ireland Italy
12 6

10 5
Sovereign credit spreads (%)

8 Sovereign credit spreads (%) 4

6 3

4 2

2 1

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Portugal Spain
16 5

4.5
14
4
Sovereign credit spreads (%)

Sovereign credit spreads (%)

12
3.5
10
3

8 2.5

2
6
1.5
4
1
2
0.5

0 0
2000 2002 2004 2006 2008 2010 2012 2000 2002 2004 2006 2008 2010 2012
Year Year

Figure 9: Observed and Model Sovereign Credit Spreads - European Countries. The figure
compares the model credit spreads and observed spreads for European countries over the period 2000-
2011. The model credit spreads are computed using the asset value estimated by maximum likelihood
from local stock market prices (see Section V), the estimated parameter values presented in Table 2,
and the calibrated parameter values described in Section V.D. The observed spreads are computed
as the difference between each country’s and Germany’s 10-year government bond yield-to-maturity.
The credit spreads are in euro.

54
 Brazil Russia
35 30
Data
Structural model

30
25

25
Sovereign credit spread (%)

Sovereign credit spread (%)

20

20

15

15

10
10

5
5

0 0
0 0.5 1 1.5 2 2.5 3 3.5 4 0 1 2 3 4 5 6 7 8
Local stock market Local stock market

Greece Italy
45 6

40
5
35
Sovereign credit spread (%)

Sovereign credit spread (%)

30 4

25
3
20

15 2

10
1
5

0 0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2
Local stock market Local stock market

Figure 10: Relation between Local Stock Market and Sovereign Credit Risk - Selected Coun-
tries. The figure illustrates the relationships between daily observed spreads and local stock market
indices over the period 2000-2011. The selection of countries includes Brazil (upper-left panel), Russia
(upper-right panel), Greece (lower-left panel), and Italy (lower-right panel). The relationship in the
data (blue crosses) is compared with that implied by the structural model (black line). The emerging
sovereign spreads consist of the JP Morgan Emerging Market Bond Index (EMBI+) spreads. The
observed spreads in Europe are computed as the difference between each country’s and Germany’s
10-year government bond yield-to-maturity. Stock market prices are given by the local Morgan Stanley
Capital International (MSCI) indices normalized to unity at the start of the sample period.

55
Table 1 : Statistics of the Model and Observed Credit Spreads. This table provides descriptive
statistics for sovereign spreads for emerging countries (Panel A) and European countries (Panel B).
The sample period spans 2000-2011. Sovereign spreads for emerging countries come from JP Morgan
Emerging Market Bond Index (EMBI+) spreads. European sovereign spreads are computed as the
difference between a country’s and the German 10-year government bond yield. The observed sovereign
spreads are compared to those implied by the model. The frequency of the data is daily and the values
are annualized.

Observed spreads Model spreads

Mean Standard Mean Standard
deviation deviation
Panel A: emerging markets

Brazil 0.0471 0.5313 0.0350 0.5326

Colombia 0.0371 0.3202 0.0191 0.4122
Mexico 0.0201 0.1142 0.0165 0.1528
Peru 0.0335 0.3054 0.0257 0.3720
Russia 0.0410 0.6168 0.0446 0.3921
Turkey 0.0409 0.3622 0.0416 0.2792
Average
Full sample 0.0366 0.3750 0.0304 0.3568
2000-2009 0.0400 0.3864 0.0335 0.3712
2010-2011 0.0195 0.0574 0.0149 0.0245

Panel B: European countries

France 0.0017 0.0348 0.0020 0.0123
Greece 0.0233 0.8196 0.0132 0.6050
Ireland 0.0104 0.3173 0.0136 0.2533
Italy 0.0062 0.1269 0.0072 0.1049
Portugal 0.0107 0.3478 0.0113 0.2677
Spain 0.0052 0.1350 0.0061 0.0331
Average
Full sample 0.0096 0.2969 0.0089 0.2127
2000-2009 0.0029 0.0530 0.0055 0.0727
2010-2011 0.0430 0.4152 0.0258 0.3452

56
Table 2 : Estimated Parameters. This table presents the parameter estimates for emerging coun-
tries (Panel A) and European countries (Panel B). The parameters are obtained from the two-stage
estimation procedure described in Section V. The level and the volatility of the asset value growth
rate are determined by a maximum likelihood of each country’s asset value using local stock market
prices. The return on public investment is obtained by a maximum-likelihood estimation of observed
sovereign credit spreads. The standard errors are reported in parentheses below the coefficients. The
last column reports the root mean square error (RMSE) between observed and model sovereign credit
spreads. The sample period spans 2000-2011. The frequency of the data is daily and the values are
annualized.

Asset growth rate Asset volatility Public investment return RMSE

µ rg
Estimate p-value Estimate p-value Estimate (%) p-value Bps
Panel A: emerging markets

Brazil 0.118 0.250 0.365 0.000 1.871 0.000 187.7

(0.102) (0.085) (0.016)
Colombia 0.206 0.006 0.267 0.000 3.038 0.000 231.9
(0.074) (0.067) (0.019)
Mexico 0.085 0.285 0.282 0.000 2.033 0.000 77.8
(0.079) (0.063) (0.009)
Peru 0.172 0.045 0.309 0.000 3.814 0.000 129.1
(0.086) (0.073) (0.022)
Russia 0.139 0.226 0.417 0.000 3.472 0.000 259.1
(0.115) (0.108) (0.038)
Turkey 0.062 0.650 0.482 0.000 0.914 0.000 131.5
(0.137) (0.114) (0.003)
Average 0.130 0.243 0.354 0.000 2.523 0.000 169.5
(0.099) (0.085) (0.018)
Panel B: European countries

France -0.052 0.448 0.243 0.000 0.116 0.000 18.2

(0.069) (0.052) (0.004)
Greece -0.197 0.017 0.282 0.000 0.194 0.000 306.8
(0.083) (0.074) (0.001)
Ireland -0.110 0.157 0.269 0.000 0.300 0.000 98.8
(0.078) (0.076) (0.002)
Italy -0.084 0.187 0.220 0.000 0.326 0.000 35.4
(0.064) (0.054) (0.004)
Portugal -0.066 0.104 0.129 0.000 0.167 0.000 132.2
(0.041) (0.036) (0.001)
Spain -0.029 0.679 0.245 0.000 0.465 0.000 77.2
(0.070) (0.056) (0.009)
Average -0.090 0.265 0.231 0.000 0.261 0.000 111.4
(0.067) (0.060) (0.003)
57
Table 3 : Analysis with U.S. Factors - Emerging Countries. The table provides results on the
relation between observed and model sovereign spreads for emerging countries. The sample period
spans 2000-2011 and the frequency of the data is daily. Column 1 reports the univariate analysis
and Column 2 includes a set of control variables, which consist of the option-implied volatility in the
U.S. (VIX), the short rate (3-month), the level (10-year) and the slope (30-year minus 3-month) of
the U.S. Treasury term structure. Column 3 considers these controls alone, while Columns 4 and 5
display results when the local stock market index replaces the model credit spreads without and with
the controls, respectively. Finally, Columns 6 and 7 reproduce Columns 4 and 5 but with the inverse
of the local stock market index to capture a non-linear relationship. The specification consists of a
panel-data estimation with country fixed effects. The heteroskedasticity consistent standard errors are
corrected for serial correlation using Newey and West’s non-parametric variance covariance estimator
and are reported in parentheses. The symbols * and ** indicate the coefficients’ significance at the
95 and 99% confidence levels, respectively.

Dependent variable: observed sovereign credit spreads (CS obs )

Model Model with Controls Linear stock market Non-linear stock market
controls alone
(1) (2) (3) (4) (5) (6) (7)

CS ( cs
) 0.885⇤⇤ 0.730⇤⇤
(0.089) (0.088)
Local stock
market index:
S -0.005⇤ -0.003⇤
(0.002) (0.001)
1/S 0.029⇤ 0.022⇤
(0.009) (0.008)
⇤⇤ ⇤⇤ ⇤⇤
VIX 0.075 0.152 0.134 0.100⇤⇤
(0.013) (0.024) (0.023) (0.024)
Short rate 0.189 4.385⇤ 3.846⇤ 1.362
(0.804) (1.134) (1.120) (0.862)
Bond yield 0.475 -1.916 -1.988 -0.349
(0.652) (0.823) (0.823) (0.587)
⇤ ⇤
Yield curve 0.194 4.014 3.464 1.176
(0.727) (1.051) (1.042) (0.761)
Constant 0.010⇤⇤ -0.032 -0.118⇤⇤ 0.052⇤⇤ -0.076 0.013 -0.033
(0.003) (0.017) (0.029) (0.005) (0.029) (0.007) (0.020)

2
Adjusted R 0.661 0.725 0.468 0.280 0.529 0.523 0.630
Model ratio 1 0.912 1.412 2.361 1.250 1.264 1.049
Observations 18,780 18,780 18,780 18,780 18,780 18,780 18,780
Test p-value of H0 : cs = 1
0.251 0.028

58
Table 4 : Analysis with U.S. Factors - European Countries. The table provides results on the
relation between observed and model sovereign spreads for European countries. The sample period
spans 2000-2011 and the frequency of the data is daily. Column 1 reports the univariate analysis
and Column 2 includes a set of control variables, which consist of the option-implied volatility in the
U.S. (VIX), the short rate (3-month), the level (10-year) and the slope (30-year minus 3-month) of
the U.S. Treasury term structure. Column 3 considers these controls alone, while Columns 4 and 5
display results when the local stock market index replaces the model credit spreads without and with
the controls, respectively. Finally, Columns 6 and 7 reproduce Columns 4 and 5 but with the inverse
of the local stock market index to capture a non-linear relationship. The specification consists of a
panel-data estimation with country fixed effects. The heteroskedasticity consistent standard errors are
corrected for serial correlation using Newey and West’s non-parametric variance covariance estimator
and are reported in parentheses. The symbols * and ** indicate the coefficients’ significance at the
95 and 99% confidence levels, respectively.

Dependent variable: observed sovereign credit spreads (CS obs )

Model Model with Controls Linear stock market Non-linear stock market
controls alone
(1) (2) (3) (4) (5) (6) (7)

CS ( cs
) 1.118⇤⇤ 1.049⇤⇤
(0.016) (0.022)
Local stock
market index:
S -0.044⇤⇤ -0.036
(0.017) (0.019)
1/S 0.020⇤⇤ 0.020⇤⇤
(0.004) (0.005)
VIX -0.011 0.004 -0.009 -0.021
(0.007) (0.003) (0.009) (0.010)
Short rate 1.084 0.963 0.693 0.282
(0.444) (0.409) (0.394) (0.262)
Bond yield -1.316 -2.139 -1.861⇤ -0.703
(0.527) (0.852) (0.645) (0.736)
Yield curve 0.868 0.693 0.212 -0.083
(0.381) (0.298) (0.320) (0.735)
⇤ ⇤ ⇤ ⇤
Constant -0.000 0.011 0.059 0.042 0.087 -0.024 0.005
(0.000) (0.009) (0.021) (0.012) (0.033) (0.007) (0.011)

2
Adjusted R 0.692 0.713 0.225 0.150 0.260 0.637 0.679
Model ratio 1 0.971 3.076 4.613 2.662 1.019 1.019
Observations 18,780 18,780 18,780 18,780 18,780 18,780 18,780
Test p-value of H0 : cs = 1
0.001 0.078

59
Table 5 : Analysis with Euro Zone Factors - European Countries. The table provides results on
the relation between observed and model sovereign spreads for European countries. The sample period
spans 2000-2011 and the frequency of the data is daily. Column 1 reports the univariate analysis and
Column 2 includes a set of control variables, which consist of the option-implied volatility in Europe
(VSTOXX), the short rate (3-month), the level (10-year) and the slope (30-year minus 3-month) of
the German Bund term structure. Column 3 considers these controls alone, while Columns 4 and 5
display results when the local stock market index replaces the model credit spreads without and with
the controls, respectively. Finally, Columns 6 and 7 reproduce Columns 4 and 5 but with the inverse
of the local stock market index to capture a non-linear relationship. The specification consists of a
panel-data estimation with country fixed effects. The heteroskedasticity consistent standard errors are
corrected for serial correlation using Newey and West’s non-parametric variance covariance estimator
and are reported in parentheses. The symbols * and ** indicate the coefficients’ significance at the
95 and 99% confidence levels, respectively.

Dependent variable: observed sovereign credit spreads (CS obs )

Model Model with Controls Linear stock market Non-linear stock market
controls alone
(1) (2) (3) (4) (5) (6) (7)

CS ( cs
) 1.118⇤⇤ 1.033⇤⇤
(0.016) (0.026)
Local stock
market index:
S -0.044⇤⇤ -0.032
(0.017) (0.014)
1/S 0.020⇤⇤ 0.020⇤⇤
(0.004) (0.005)
VSTOXX 0.000 0.037 0.017 -0.014
(0.008) (0.013) (0.009) (0.015)
Short rate -0.701 -1.323 -2.126 -1.634
(0.282) (0.549) (0.867) (0.721)
Bond yield 0.189⇤⇤ -0.107 0.876 1.055
(0.033) (0.120) (0.486) (0.697)
⇤
Yield curve -0.652 -1.118 -2.162 -1.836
(0.197) (0.479) (0.912) (0.742)
⇤ ⇤ ⇤ ⇤
Constant -0.000 0.023 0.059 0.042 0.089 -0.024 0.014
(0.000) (0.010) (0.020) (0.012) (0.032) (0.007) (0.010)

2
Adjusted R 0.692 0.714 0.253 0.150 0.281 0.637 0.690
Model ratio 1 0.969 2.735 4.613 2.462 1.086 1.003
Observations 18,780 18,780 18,780 18,780 18,780 18,780 18,780
Test p-value of H0 : cs = 1
0.001 0.264

60
Table 6 : Sensitivity Analysis of the Estimation Results. This table presents a sensitivity analysis
of the estimation results for emerging countries (Panel A) and European countries (Panel B). The
table illustrates the results averaged across countries for different values of calibrated parameters , ,
and r. The first two rows provide statistics on the estimated asset value, the next three rows reports
the parameter estimates, while the last row reports the root mean square error (RMSE) between
observed and model sovereign credit spreads. The parameter estimates are obtained from the two-
stage estimation procedure described in Section V. The level and the volatility of the asset value growth
rate are determined by a maximum likelihood of each country’s asset value using local stock market
prices. The return on public investment is obtained by a maximum-likelihood estimation of observed
sovereign credit spreads. The standard errors are reported in parentheses below the coefficients. The
sample period spans 2000-2011. The frequency of the data is daily and the values are annualized.

Baseline Debt haircut Default costs Risk-free rate r

-0.2 +0.2 -2% +2% -1% +1%

Panel A: emerging markets

Parameter values 0.55 0.95 2.1% 6.1% 3.46% 5.46%

Asset value V
Minimum 0.584 0.594 0.580 0.579 0.588 0.585 0.583
Maximum 4.330 4.274 4.352 4.357 4.303 4.316 4.339
Growth rate µ 0.130 0.130 0.131 0.131 0.130 0.130 0.130
(0.099) (0.099) (0.099) (0.099) (0.098) (0.099) (0.099)
Volatility 0.353 0.356 0.354 0.355 0.352 0.354 0.353
(0.010) (0.012) (0.010) (0.010) (0.010) (0.010) (0.010)
Public return rg (%) 2.523 2.520 2.521 2.493 2.554 2.035 2.941
(0.020) (0.020) (0.017) (0.016) (0.018) (0.013) (0.020)
RMSE (bps) 169.5 166.8 170.7 170.7 168.2 160.4 178.8

Panel B: European countries

Parameter values 0.4 0.8 3% 7% 2.52% 4.52%

Asset value V
Minimum 0.260 0.265 0.245 0.245 0.247 0.249 0.245
Maximum 1.081 1.081 1.081 1.081 1.081 1.081 1.081
Growth rate µ -0.090 -0.089 -0.092 -0.092 -0.091 -0.091 -0.092
(0.067) (0.066) (0.069) (0.069) (0.069) (0.069) (0.069)
Volatility 0.231 0.225 0.242 0.242 0.237 0.238 0.240
(0.008) (0.009) (0.008) (0.008) (0.009) (0.008) (0.009)
Public return rg (%) 0.261 0.265 0.301 0.303 0.303 0.326 0.266
(0.004) (0.004) (0.006) (0.005) (0.005) (0.004) (0.005)
RMSE (bps) 111.4 108.7 113.1 113.0 111.8 113.7 112.6

61
Table 7 : Analysis of Time-varying Model Parameters. The table examines how the time variation
in the model parameters help explain observed sovereign spreads for emerging and European countries.
The sample period spans 2000-2011 and the frequency of the data is daily. The first three columns
analyze emerging spreads, while the last three columns analyze European spreads. Columns 1 and 4
include, in addition to the model-implied credit spreads, the conditional volatility of each country’s
asset growth computed with the GARCH(1,1) model. Columns 2 and 5 consider the time-varying risk-
free rate, measured by the 10-year U.S. Treasury rate and German Bund rate, respectively. Finally,
Columns 3 and 6 display results when both factors are included. The specification consists of a panel-
data estimation with country fixed effects. The heteroskedasticity consistent standard errors are
corrected for serial correlation using Newey and West’s non-parametric variance covariance estimator
and are reported in parentheses. The symbols * and ** indicate the coefficients’ significance at the
95 and 99% confidence levels, respectively.

Dependent variable: observed sovereign credit spreads (CS obs )

Emerging countries European countries
Asset Risk-free Both Asset Risk-free Both
volatility rate factors volatility rate factors
(1) (2) (3) (4) (5) (6)

CS 0.880⇤⇤ 0.853⇤⇤ 0.844⇤⇤ 1.094⇤⇤ 1.029⇤⇤ 1.010⇤⇤

(0.066) (0.069) (0.046) (0.014) (0.025) (0.030)
Asset volatility 0.040⇤⇤ 0.041⇤⇤ 0.021 0.019
(0.004) (0.003) (0.025) (0.022)
USD risk-free rate 0.255 0.287
(0.234) (0.231)
Euro risk-free rate -0.473 -0.457
(0.307) (0.274)
Constant -0.003 0.000 -0.014 -0.005 0.019 0.014
(0.003) (0.012) (0.011) (0.005) (0.012) (0.007)

2
Adjusted R 0.710 0.669 0.720 0.700 0.712 0.719
Model ratio 0.931 0.988 0.918 0.989 0.972 0.962
Observations 18,780 18,780 18,780 18,780 18,780 18,780

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