External shocks and the non-linear dynamics of Brady bond spreads in a regime-switching VAR [An article from: Journal of International Financial Markets, Institutions & Money]

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Description:
This paper analyzes the response of interest rate differentials between yields on Brady bonds and risk-less bonds to shocks in US interest rates and to conditions in global emerging bond markets. The effect of those shocks is likely to be non-linear. To capture this non-linear propagation, the reaction of refinancing conditions to shocks is investigated within a Markov-switching VAR framework that endogenously separates a crisis regime from a no-crisis regime. Regime-dependent impulse response functions reveal the non-linear response to external shocks. In periods of financial turbulences the positive impact of US rates breaks down. Likewise, shocks to other emerging markets are contagious in the sense that their negative impact is much more pronounced during times of financial distress.