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“Sovereign Default Risk under Model Uncertainty” (PDF) I claim that model uncertainty regarding the true process governing economic fundamentals can account for both the level in sovereign debt returns and the structure of the cross section of returns across countries. In the paper, I introduce misspecification doubts and ambiguity-averse investors in a model of sovereign default. In this framework, where default can be an optimal outcome and default decisions are more likely to occur under low income scenarios, model uncertainty generates a risk premium without the need of a correlation between foreign investors’ consumption and default. Keeping default probabilities at historical levels, the introduction of ambiguity-averse investors can explain the level of the returns observed in the data. Investors charge a premium on risky debt in order to guard themselves against possible misspecification errors regarding the "approximating" model of the economy. I quantify the premium, and characterize its main component, the market price for uncertainty. While risk premiums are increasing in debt, the market price of uncertainty is decreasing, partially offsetting the higher risk from default. A calibrated model captures these effects, and shows the role of overall uncertainty in the premium. Emerging economies, where the model that governs the data is usually harder to identify, are prone to have larger levels of model uncertainty, and hence higher risk premiums. “Understanding the Risk Premium in Argentina’s GDP-indexed units”.

Joint with Luca Ricci and Marcos Chamon (IMF). (Under revision for resubmission). We price GDP-indexed units issued by Argentina, and identify the main sources behind the large premium observed in their initial market valuation. This is an extension of the working paper below on the same subject, with the addition of an endogenous market price of default risk, interest rate risk, and the introduction of model uncertainty regarding the true process for GDP. “Is there a Novelty Premium on New Financial Instruments? The Argentine experience with GDP-Indexed Warrants” (PDF)

IMF Working Paper 08/109. April 2008. Joint with Luca Ricci and Marcos Chamon (IMF). This paper examines the Argentine experience with GDP-indexed warrants in order to gauge the existence of a novelty premium on new financial instruments. It uses Monte Carlo to calculate the value of the asset, on the basis of various forecast assumptions. The results show that the residual premium paid by these warrants over standard bonds declined significantly by about 600 points between December 2005 and July 2007. This suggests that financial innovation may be associated with premia, which decay reasonably fast. “A Note on the Valuation of Risky Debt under Model Uncertainty” Secondary Paper.

In a similar framework to Merton’s model of default, I show how model uncertainty, in a continuous time model, can affect the risk premium, and characterize the market price of model uncertainty.