A Structural Model for Sovereign Credit Risk

This paper provides, and empirically estimates, a structural model of sovereign default risk on external debt. The sovereign endogenously determines its level of foreign debt and default policy. Consistent with default crisis episodes, the sovereign and its lenders bargain at default over a reduction of the debt service. The potential for debt restructuring o¤ers the sovereign greater incentive to default. This model o¤ers theoretical predictions of the relationship between credit spreads and related macro-variables that are consistent with the empirical literature. I also compare estimates of daily credit spreads implied by the structural model with observed EMBI+ spreads for Brazil, Mexico, Peru, and Russia over the period 1998-2006. In a panel analysis, the model explains about 92 % of the time variation in daily credit spreads. In contrast to some recent studies, there remains limited scope for additional explanation from U.S. Treasury rates and the VIX index