Emerging Market Risk Premia Fluctuations: A micro founded decomposition

This paper aims at deepening our understanding of emerging market (EM) sovereign bond spread fluctuations. I first build a noisy rational expectation model, with imperfect information, in which some informed investors receive a noisy private signal about the emerging country’s ability and willingness to repay its sovereign debt. I show that, in equilibrium, sovereign bond prices and spreads depend on country characteristics, international capital flows and more surprisingly, on how dispersed information about the EM sovereign bond market is. I then empirically test the relevance of this equilibrium relation, using a monthly Panel data for 11 EMs over 2000-2012. Interestingly, the empirical investigation provides strong evidence in favor of the parsimonious representation of the EM sovereign bond spreads the theoretical model delivers. As theoretically predicted, country spreads increase with less liquidity available, with diminishing international reserves, with worsening governance and crucially, with more dispersed information about the EM sovereign bond market. The latter is a novel and salient result for EMs.