| This paper presents a model of sovereign country default spreads, which takes into account stochastic movements of risk-free rates and production function. Default occurs at the first time when the value of objective function with default is larger than the value of objective function with borrowing and debt service. First, the easier and intuitive model is presented--the discrete one, and some numerical results on spreads are given. Then the general continuous time model is developed and an explicit formula for the probability of default is presented. This theory predicts positive correlations between risk-free interest rates and risk spreads which are reported for Brady bonds. |
