Daniel Waldenström: Dept. of Economics, Stockholm School of Economics, Postal: Stockholm School of Economics, P.O. Box 6501, SE-113 83 Stockholm, Sweden
Abstract: This paper shows that geographical investor heterogeneity strongly influences sovereign risk. While standard sovereign debt models mainly attribute the absence of sovereign defaults to foreign creditor retaliation, a new theoretical literature argues that domestic creditors also affect borrowing governments’ default decisions through channels of domestic politics. This paper examines this controversy using a newly assembled dataset on cross-listed Scandinavian sovereign yields traded at markets that abruptly went from integration to segmentation by capital controls and World War II. The results strongly suggest that domestic and foreign bond investors assessed different sovereign risks whereas more standard explanations based on macroeconomic factors, portfolio choice or risk aversion added little explanatory value. The study also documents large effects on recorded asset prices from institutional trading constraints (e.g., price limits), an issue largely neglected by previous research in historical long-run asset returns.
25 pages, First version: February 9, 2005. Revised: February 18, 2005.
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