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Endogenous risk premium and terms of
trade: evidence for developing countries*
Sergio Barone
Ricardo Descalzi
ARNOLDSHAIN SEMINAR XI.
June 25-28, 2013. University of Antwerp,
Beliguim.
Presentation
1. Introduction
2. Theoretical Framework and Main Hyphotesis

Review of literature

Working hyphotesis
3. Empirical aplicaction

Estimation estrategy

Results
4. Conclutions
1. Introduction
GENERAL PROBLEM: scarce capital flows to poor countries.
Why capital flow from poor to rich countries?
Geographical
Distribution
income
leveldelofFlujo
capital
flows 1970-2004.
Distribución Geógrafica
y porand
niveles
de Ingreso
de Capitales
1970 a 2004
East Asia & Pacific
Europe & Central Asia
Latin America & Caribbean
Middle East & North Africa
North America
Sub-Saharan Africa
South Asia
TOTAL
Low
0.08%
0.01%
0.03%
0.02%
0.53%
0.50%
1.16%
Lower middle Upper middle
2.61%
0.28%
0.18%
1.38%
1.31%
1.90%
0.65%
0.19%
0.05%
0.03%
4.83%
High
14.48%
49.41%
1.95%
24.10%
0.32%
4.07%
89.94%
TOTAL
17.44%
50.99%
3.24%
2.82%
24.10%
0.90%
0.52%
100.00%
Fuente: Elaboración propia en base a datos de Lane, P. and Milesi-Ferretti, G. "The External Wealth of Nations
Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004. IMF Working Paper 06/69.
We can explain this direction of capital flow from differential between the
interest rate paid by the rich and poor countries for theirs debts? , How
do you explain this difference?
1. Introduction
More specifically:
What the relation of the terms of trade and the risk
premium?
2. Theoretical Framework and Working Hyphotesis
Review of Literature:
Lucas (1990): He points out three reasons :
(a) The capital return (marginal product of capital in terms of capital per capita) is not
equalize across countries by differences in human capital stock between rich and poor
countries;
(b) knowledge spillovers;
(c) political risk: due to the difficulty of the creditor country to ensure compliance with
loan agreements (sovereign risk).
2. Theoretical Framework and Working Hyphotesis
Alfaro, L., Kalemli-Ozcan, S., Volosovych, V. (2005) classifiy theoretical
explanations of the Lucas paradox in two groups
(a) differences between the fundamentals; (i) factors of production "lost"
(specification problems in aggregate production function), (ii)
government policies, (iii) institutional structure and theirs effects on
TFP (Alfaro contribution)
(b) Imperfections in the capital market;
(i) sovereign risk;
(ii) asymmetric information (a) ex-ante (adverse selection); (b)
interim (moral hazard) Gertler and Rogoff (1990); (c) ex-post
(expensive verification of events);
2. Theoretical Framework and Working Hyphotesis
 Two periods, one good, endowment
W1 , W2 
 Two investing posibilities in order to utilize W1 in 1.
 Lend abrod at tisk-free rate
r
 Invest in a risky technology:
Units of capital
in period 1
yield in 2:

0
units output with probability
 k 
units output with probability 1    k 
• Individual budget restriction in the first period is:
 Where
W1  b  k
b is the amount that the economy borrows from
the rest of the world
2. Theoretical Framework and Working Hyphotesis
•With regard to the information structure , it is supposed that the
lenders are able to observe endowments
, the production
  
, Wamount

function
andWthe
that debtor country borrows.
1
2
•But, they can not observe what the borrower does with the funds
he borrow from abroad: that is, creditors are not allowed to
observed and the borrower, for example, could secretly lend
abroad rather than invest in the proyects. Finally, the realized
aoutput is freely observed by lenders.
Capital stock with V  k *
Ẑ

MR
IC
V
k
k*
Funtion IC (Incentive Constraint): It equates the expected gain from investing with
the country´s opportunity cost (given by the risk-free rate) of secretly holding assets
*
abroad. If Ẑ increases, then optimal k fall because the expected profit from invested
is reduced.
Function MR (Market Return): This equation indicates that lenders must recieve the
market rate of return. When k increases, the poor economy increase her borrowing,
then she has to offer to creditors a greater rate to get additional funds.
Given the uncollateralized borrow k  V the risk-premium is endogenous. The
economy must paid above the free-risk rate to financing capital above their
Wealth or collateral. The rate of interest is:
Z g  W2
r
r 

r
k V
 k 
L
Terms of Trade Shocks and Risk-Premium
Ẑ

MR
MR´
IC
V´
V
k*
3.Empirical Aplication: Estimation Estrategy
3. Empirical Aplication
Expected Results
Variable
TOT
RD
M 2GDP
INFL
Coefficient
1
2
3
DEGDP
AC
GROWTH
4
5
6
7
TOT
GROWTH
1L 1M
 7 L  7M
Expected Sign
Negative
Positive
Negative
Positive
Negative
Negative
Negative
Negative
No Significant
3.Empirical Aplication
We estimeted POLS, RE, FGLS, FE y FEFGLS. Dependent variable logarithm of
the risk premium (PR).
Two Samples:
(i) N=75 t=30; variables incluided :
logarithm of terms of trade (LNTOT),
Ratio of dependency (RD),
financial deepness (M2GDP),
inflation (INFL),
Trade Openness (AC)
Growth (GROWTH).
(ii) N=69 t=30; Financial Openness de Facto (APF)
3. Empirical Aplication : Results
3. Empirical Aplication : Results
4. Conclusions
 The risk premium is negatively correlated with the Terms of





Trade. That is, it checks the collateral effect of the terms of
trade.
The relationship between the terms of trade and the risk
premium is higher for less developed countries.
Inflation directly affects the risk premium. The anti-inflation policy
is important to reduce country risk and reverse the shortage of
funds to finance their development.
Trade openness is significant only for upper middle income
countries and high.
Growth is not significantly different from zero for low income
countries. For other categories of income is significant and
negative.
For low-income countries terms of trade improvement appear to
be more relevant than the growth.