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Default Risk and Risk Averse International Investors

Lizarazo, Sandra (2010): Default Risk and Risk Averse International Investors.

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Abstract

This paper develops a model of debt and default for small open economies that interact with risk averse international investors. The model developed here extends the recent work on the analysis of endogenous default risk to the case in which international investors are risk averse agents with decreasing absolute risk aversion (DARA). By incorporating risk averse investors who trade with a single emerging economy, the present model offers two main improvements over the standard case of risk neutral investors: i.) the model exhibits a better fit of debt-to-output ratio and ii.) the model explains a larger proportion and volatility of the spread between sovereign bonds and riskless assets. The paper shows that if investors have DARA preferences, then the emerging economy's default risk, capital flows, bond prices and consumption are a function not only of the fundamentals of the economy---as in the case of risk neutral investors---but also of the level of financial wealth and risk aversion of the international investors. In particular, as investors become wealthier or less risk averse, the emerging economy becomes less credit constrained. As a result, the emerging economy's default risk is lower, and its bond prices and capital inflows are higher. Additionally, with risk averse investors, the risk premium in the asset prices of the sovereign countries can be decomposed into two components: a base premium that compensates the investors for the probability of default (as in the risk neutral base) and an ``excess'' premium that compensates them for taking the risk of default.

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