Indeterminacy in Sovereign Debt Markets: an Empirical Investigation

February 2015
Luigi Bocola, Alessandro Dovis

How important was non-fundamental risk in driving interest rate spreads during the euro-area sovereign debt crisis? To answer this question, we consider a model of sovereign borrowing with three key ingredients: multiple debt maturities, risk averse lenders and coordination failures á la Cole and Kehoe (2000). In this environment, lenders’ expectations of a default can be self-fulfilling, and market sentiments contribute to variation in interest rate spreads along with economic fundamentals. We show that the joint distribution of interest rate spreads and debt duration provides information to distinguish between fundamental and non-fundamental sources of default risk. We calibrate the model to match the empirical distribution of Italian sovereign spreads and debt duration. The process for the lenders’ stochastic discount factor, a key imput in our analysis, is estimated using state of the art asset pricing techniques. Our preliminary results indicate that the rise in Italian interest rate spreads over the 2011-2012 period was mostly the result of high risk premia and bad economic fundamentals, with a limited role played by non-fundamental uncertainty. We show how this information is critical to understand the implications of the OMT program announced by the ECB.