Modelling Long Memory and Risk Premia in Latin American Sovereign Bond Markets Alfonso Mendoza V. ∗ The University of York Department of Economics and Related Studies October, 2004 Abstract A family of credit risk models is proposed to capture three salient features of Latin American (LA) Sovereign Bond Markets: individual Long Range Dependence in volatility–Long Memory (LM)–, high fractional comovement and time varying risk premia. Evidence in fa- vor of LM is uncovered and the extent of Default Risk Contagion in these markets during the nineties is measured. Among others, the re- sults suggest that the response of bond spread changes to volatility shocks is not statistically different, indicating that a common source may be driving the market. Also, the extent of fractional comovement is high and the magnitude of the risk premia for investing in these bond markets is substantial. Our suggested family of bivariate Fractional In- tegrated GARCH-in-Mean models is preferred to Brunetti (2000) and Teyssière (1998) processes as indicated by Schwartz Information Cri- teria and Likelihood Ratio tests. Keywords: Financial Stability, Credit Risk, Default Risk Contagion, Long Memory, Bivariate FIGARCH(1,d,1)-in-Mean. JEL: C14, C32, F34, F42, G12, G15. ∗ The author would like to acknowledge the sharp comments and suggestions made by Profr. Peter N. Smith and Dr. Liudas Giraitis. Contact details: Fax. +44 (1) 904 433759; e-mail: a.mendoza@liverpool.ac.uk; amv101@yahoo.com 1