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The Sovereign Default Puzzle: Modelling Issues and Lessons for Europe

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  • Cohen, Daniel
  • Villemot, Sébastien

Abstract

Why do countries default? This seemingly simple question has yet to be adequately answered in the literature. Indeed, prevailing modelling strategies compel the to choose between two unappealing model features: depending on the cost of default selected by the modeler, either the debt ratios are too high and the probability of default is too low or the opposite is true. In view of the historical evidence that countries always default after a crisis, we propose a novel approach to the theory of debt default and develop a model that matches the key stylized facts regarding sovereign risk.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8971.

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Date of creation: May 2012
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Handle: RePEc:cpr:ceprdp:8971

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Keywords: Levy stochastic processes; Sovereign debt;

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  1. Leonardo Martinez & Horacio Sapriza & Juan Carlos Hatchondo, 2010. "Quantitative Properties of Sovereign Default Models," IMF Working Papers 10/100, International Monetary Fund.
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  9. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
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  22. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
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