NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH
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Sandra Lizarazo

International Monetary Fund
1900 Pennsylvania Ave NW
Washington, DC, 20431

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Institutional Affiliation: International Monetary Fund

NBER Working Papers and Publications

November 2017Sovereign Risk Contagion
with Cristina Arellano, Yan Bai: w24031
We develop a theory of sovereign risk contagion based on financial links. In our multi-country model, sovereign bond spreads comove because default in one country can trigger default in other countries. Countries are linked because they borrow, default, and renegotiate with common lenders, and the bond price and recovery schedules for each country depend on the choices of other countries. A foreign default increases the lenders’ pricing kernel, which makes home borrowing more expensive and can induce a home default. Countries also default together because by doing so they can renegotiate the debt simultaneously and pay lower recoveries. We apply our model to the 2012 debt crises of Italy and Spain and show that it can replicate the time path of spreads during the crises. In a counterfactua...
 
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