Bougias, A. and A. Episcopos (2022). Sovereign debt dynamics with serial defaults. Available at SSRN

Abstract. We propose a structural model of sovereign debt valuation that explicitly incorporates the possibility of serial defaults. We derive closed-form stock and sovereign bond prices for a government that can strategically default multiple times on its outstanding debt. Exploiting the information content of the stock and CDS markets, we calibrate the model for a sample of eight serial defaulting countries through a two-stage maximum likelihood procedure. Consistent with the theoretical predictions, serial default risk is an important risk factor of sovereign bonds. Specifically, the serial default premium is on average 60 basis points and explains 15% of the sovereign credit spread. On the other side, serial defaults are not an important risk factor of stock returns, as the former reduce the stock prices by only 20 basis points. Overall, our model resembles the documented stylized facts of serial defaulters and provides a new way of recovering investors' serial default risk exposure from the equity and credit markets.