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Contagion of financial crises in sovereign debt markets

Lizarazo, Sandra (2009): Contagion of financial crises in sovereign debt markets.

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This paper develops a DSGE model of sovereign default and contagion for small open economies that have common risk averse international investors. The financial links generated by these investors explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices. In equilibrium, these variables are a function of both an economy’s fundamentals and the fundamentals of other economies. The model replicates the Wealth and Portfolio Recomposition channels of contagion and identifies another channel: the Risk Diversification channel of contagion. Quantitatively, the model is consistent with the contagion of the Argentinean crisis to Uruguay.

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