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Default Premium

Default Premium by Luis Catão
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We re-assess the view that sovereigns with a history of default are charged only a smalland/or short-lived premium on the interest rate warranted by observed fundamentals. Our reassessmentuses a metric of such a 'default premium' (DP) that is consistent withasymmetric information models and nests previous metrics, and applies it to a much broaderdataset relative to earlier studies. We find a sizeable and persistent DP: in 1870-1938, itaveraged 250 bps upon market re-entry, tapering to around 150 bps five years out; in 1970-2011 the respective estimates are about 400 and 200 bps. We also find that: (i) theseestimates are robust to many controls including on actual haircuts; (ii) the DP accounts for asmuch as 60% of the sovereign spread within five years of market re-entry; (iii) the DP riseswith market exclusion spells. These findings help reconnect theory and evidence on whysovereign defaults are infrequent and earlier debt settlements are desirable.
International Monetary Fund; July 2015
58 pages; ISBN 9781513542850
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Title: Default Premium
Author: Luis Catão; Rui Mano