Contagion of financial crises in sovereign debt markets

This paper develops a DSGE model of sovereign default and contagion for small open economies that have common risk averse international investors. The financial links generated by these investors explain the endogenous determination of credit limits, capital flows, and the risk premium in sovereign bond prices. In equilibrium, these variables are a function of both an economy’s own fundamentals and the fundamentals of other economies. The model is able to replicate both the Wealth and Portfolio Recomposition channels of contagion. Quantitatively, the model is consistent with the contagion of the Argentinean crisis to Uruguay and the Russian crisis to Brazil.