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Quantitative properties of sovereign default models: solution methods

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  • Juan Carlos Hatchondo

    (Federal Reserve Bank of Richmond)

  • Leonardo Martinez

    (International Monetary Fund)

  • Horacio Sapriza

    (Federal Reserve Board of Governors)

Abstract

We study the sovereign default model that has been used to account for the cyclical behavior of interest rates in emerging market economies. This model is often solved using the discrete state space technique with evenly spaced grid points. We show that this method necessitates a large number of grid points to avoid generating spurious interest rate movements. This makes the discrete state technique significantly more inefficient than using Chebyshev polynomials or cubic spline interpolation to approximate the value functions. We show that the inefficiency of the discrete state space technique is more severe for parameterizations that feature a high sensitivity of the bond price to the borrowing level for the borrowing levels that are observed more frequently in the simulations. In addition, we find that the efficiency of the discrete state space technique can be greatly improved by (i) finding the equilibrium as the limit of the equilibrium of the finite-horizon version of the model, instead of iterating separately on the value and bond price functions and (ii) concentrating grid points in asset levels at which the bond price is more sensitive to the borrowing level and in levels that are observed more often in the model simulations. Our analysis is also relevant for the study of other credit markets. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2010.03.001
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 13 (2010)
Issue (Month): 4 (October)
Pages: 919-933

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Handle: RePEc:red:issued:08-133

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Related research

Keywords: Emerging economies; Sovereign debt; Default; Numerical methods;

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Cited by:
  1. Leonardo Martinez & Juan Carlos Hatchondo & Juan M. Sanchez, 2012. "Mortgage Defaults," IMF Working Papers 12/26, International Monetary Fund.
  2. Daniel Cohen & Sébastien Villemot, 2012. "The sovereign default puzzle: Modelling issues and lessons for Europe," Working Papers halshs-00692038, HAL.
  3. Stähler, Nikolai, 2011. "Recent developments in quantitative models of sovereign default," Discussion Paper Series 1: Economic Studies 2011,17, Deutsche Bundesbank, Research Centre.
  4. Cohen, Daniel & Villemot, Sébastien, 2012. "The Sovereign Default Puzzle: Modelling Issues and Lessons for Europe," CEPR Discussion Papers 8971, C.E.P.R. Discussion Papers.
  5. Satyajit Chatterjee & Burcu Eyigungor, 2010. "Maturity, indebtedness, and default risk," Working Papers 10-12, Federal Reserve Bank of Philadelphia.
  6. Leonardo Martinez & Juan Carlos Hatchondo & Cesar Sosa Padilla, 2011. "Debt Dilution and Sovereign Default Risk," IMF Working Papers 11/70, International Monetary Fund.
  7. Juan Carlos Hatchondo & Leonardo Martinez, 2010. "The politics of sovereign defaults," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 291-317.
  8. Demian Pouzo & Ignacio Presno, 2012. "Sovereign default risk and uncertainty premia," Working Papers 12-11, Federal Reserve Bank of Boston.
  9. Juan Carlos Hatchondo & Francisco Roch & Leonardo Martinez, 2012. "Fiscal Rules and the Sovereign Default Premium," IMF Working Papers 12/30, International Monetary Fund.
  10. Villemot, Sébastien, 2012. "Accelerating the resolution of sovereign debt models using an endogenous grid method," Dynare Working Papers 17, CEPREMAP.

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