Imperfect Information and Contagion in Capital Markets: A Test on Emerging Markets Sovereign Bonds

In this article, we test the importance of the role played by imperfect information in emerging markets sovereign bonds. We develop a model of secondary market bond spreads that incorporates measures of both risk and ambiguity created by imperfect information. We test it on a large set of emerging markets over a recent period by using bid and ask spreads as a proxy for the level of ambiguity in each market. We find strong evidence that ambiguity is a key element in sovereign spread determination in secondary markets. We also show that the concept of ambiguity is a good candidate for justifying contagion during a crisis. In particular, we are able to discriminate between crises that arose due to a global disturbance on perceived ambiguity from others.