Contagion of Financial Crises in Sovereing Debt Markets
This paper develops a quantitative model of debt, default, and contagion of financial crises for small open economies that interact with risk averse international investors. The paper extends the recent literature on endogenous default risk to the case in which several emerging economies that cannot credibly commit to honor their international debts have common investors. The existence of common investors with preferences that exhibit decreasing absolute risk aversion generates financial links between the emerging economies sovereign debt markets that help to explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices as function not only of the economy's fundamentals, the investors' characteristics (wealth, and degree of risk aversion) but more importantly of the fundamentals of other emerging economies. Therefore this paper provides a theoretical formalization that is the base for and endogenous explanation of the contagion of financial crises.
Contagion; Sovereign Debt; Financial Links; Default
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