Sovereign debt and loss aversion
Abstract
Agents in developed countries invest too little of their wealth in foreign sovereign bonds (home bias). Moreover, they require a risk premium on sovereign bonds which is too high to be explained by a reasonable degree of risk aversion (bond premium puzzle). Are creditors in sovereign debt markets loss averse? In my first paper, I develop a model of costly debt default, in which the home government maximizes the expected utility of a representative risk neutral agent by selling zero-coupon bonds to loss averse foreign investors. The model can explain both puzzles. In the second paper, I introduce a new database containing realized returns on virtually all sovereign bonds quoted on the London Stock Exchange over the period 1864-1929. Then, I estimate loss aversion and risk aversion parameters in a simple framework by GMM. The presence of loss aversion is supported by the data. Moreover, the model with loss and risk aversion performs quite better than the CAPM. In the third paper, develop an intertemporal model of costly debt default, in which risk neutral home agents maximize their expected utility by selling bonds to loss averse foreign creditors or retiring debt. Then, I test this model by using an equally weighted minimum distance estimator (EWMD). The estimated coefficient of loss aversion is significant and quite close to the estimates obtained by other authors.
Recommended Citation
Petronilla Nicoletti,
"Sovereign debt and loss aversion"
(January 1, 2004).
Boston College Dissertations and Theses.
Paper AAI3142882.
http://escholarship.bc.edu/dissertations/AAI3142882
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