Macro-Finance Approach to Sovereign Debt Spreads and Returns (Job Market Paper)
Foreign currency sovereign bond spreads tend to be higher than historical sovereign credit losses, and cross-country spread correlations are larger than their macro-economic counterparts. Foreign currency sovereign debt exhibits positive and time-varying risk premia, and standard linear asset pricing models using US-based factors cannot be rejected. I develop a quantitative and tractable continuous-time model of endogeneous sovereign default in order to account for these stylized facts. My framework leads to pseudo-closed form expressions for key macro and asset pricing moments of interest, helping disentangle which of the model features influences credit spreads, expected returns and cross-country correlations. Standard pricing kernels used to explain properties of US equity returns can be nested into my quantitative framework in order to test the hypothesis that US-based bond investors are marginal in sovereign debt markets. I also show how to leverage my model to study the early 1980’s Latin American debt crisis, during which high short term US interest rates and floating rate dollar-denominated debt led to a wave of sovereign defaults. Online Appendix
This article analyzes a firm prone to debt runs, and the effect of its portfolio liquidity composition on the run behavior of its creditors. The firm holds cash and an illiquid cash flow generating asset, and is financed with debt held by a continuum of creditors. At each point in time, a constant fraction of the firm’s outstanding liabilities matures, leading the maturing creditors to decide whether to roll-over or ask for their funds back. When the firm’s portfolio value deteriorates, creditors are inclined to run, but their propensity to run decreases with the amount of available liquidity resources. The theory has policy implications for micro-prudential bank liquidity regulation: for any leverage ratio, it characterizes the quantity of liquidity reserves a firm should hold in order to deter a run. I solve the model numerically and perform comparative statics, varying the firm’s illiquid asset characteristics and the firm’s debt maturity profile. I discuss the influence of the firm’s portfolio choice and dividend policy on the run behavior of creditors. The model can also be transported into an international macroeconomic context: the firm can be reinterpreted as a central bank/government, having issued foreign-currency denominated sovereign debt that is regularly rolled over. A high debt-to-GDP ratio combined with low levels of foreign currency reserves will prompt foreign creditors to run. The theory can therefore provide guidance on the appropriate sizing of central banks’ foreign currency reserves for countries issuing large amounts of short term hard currency debt.
Rigid Wages, Seniority Rules, and Unemployment Duration (with Fernando Alvarez and Rob Shimer)
This paper examines the impact of unions on unemployment and wages in a dynamic equilibrium search model. We model a union as imposing a minimum wage and rationing jobs to ensure that the union’s most senior members are employed. This generates rest unemployment, where following a downturn in their labor market, unionized workers are willing to wait for jobs to reappear rather than search for a new labor market. Introducing unions into a dynamic equilibrium model has two implications, which others have argued are features of the data: the hazard of exiting unemployment at long durations is very low when the union-imposed minimum wage is high; and a high union-imposed minimum wage generates a compressed wage distribution and a high turnover rate of jobs.
Intermediary Capital, Corporate Debt Spreads, and the Real Economy (with Paymon Khorrami and Jung Sakong)
In this paper, we develop a general equilibrium model with production and financial intermediation to explain the interactions between credit spreads, defaults, and the macroeconomy. There are both benefits and costs to financial intermediation. Intermediaries are useful because they allow firms to lever up, and because they allow households to hold deposits. However, debt is risky due to defaults, and financial distress imposes real costs on the rest of the economy. The result is that intermediation by specialized investors amplifies macroeconomic fluctuations, as intermediary capital is limited. This amplification is particularly strong when corporate leverage is high, and can lead to prolonged recessions through debt overhang. Aside from the inclusion of risky debt, our model is distinguished from the financial accelerator literature by delineating clear economic roles for firms, intermediaries, and households.