What drives credit risk in emerging markets? The roles of country fundamentals and market co-movements

This paper uses bond prices to investigate how the creditworthiness of Argentina, Brazil, Mexico and Venezuela is influenced by global, regional and country-specific factors. Each country's distance-to-default is estimated monthly for 1994–2001, by fitting the structural model of Cathcart and El-Jahel [Cathcart, L., El-Jahel, L., 2003. Semi-analytical pricing of defaultable bonds in a signalling jump-default model. The Journal of Computational Finance 6, 91–108] with a Kalman Filter to Brady bonds. A small set of variables is able to explain up to 80% of the variance of the estimated distance-to-default for each country. Surprisingly, country-specific variables account for only about 8% of the explained variance; the largest part of the variance (45%) is explained by regional factors, which relate to joint stock-market returns, volatility and market sentiment; global conditions, related mainly to US stock-market returns, explain another 25% of the variance. Of the 20% variance which remains unexplained, more than half is due to another common (but unidentified) factor. The conclusion is that the creditworthiness of these four emerging markets is driven mainly by a common set of factors, which are related closely to stock markets in the region and the United States.