Determinants of the Brazilian Sovereign Risk : A Two-Factor Structural Model

This paper develops a two-factor credit risk model based on the contingent claim structural models for pricing the Brazilian sovereign risk implicit in the Brazilian C-Bond. The underlying variable that captures the default probability is a measure of the macroeconomic fundamentals associated with the assumption that agent's expectation changes smoothly over time. This approach incorporates both changes into the pricing model: the macroeconomic fundamentals and the creditor's expectations. We identify the following applications for the proposed model: i) how macroeconomic policies affect the evolution of the credit spread; ii) estimation of the default probability and the associated risk premium; and iii) the credit spread forecast. We reach the following conclusions: i) the proposed model has a forecast ability higher than the random walk; ii) both quantities - fundamentals and expectations - are important to explain the credit spread evolution; iii) the risk premium is not constant over time; iv) at the margin, fundamentals are more important than the risk premium to forecast thespread; and v) the recent increase in the risk premium for Brazil indicates there is significant room to reduce the credit spread just as a consequence of an improvement over expectations