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Valuation of Sovereign Debt with Strategic Defaulting and Rescheduling

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  • Michael WESTPHALEN

    (École des HEC, University of Lausanne and FAME)

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    Abstract

    This paper provides a simple model of the rescheduling of debt following a sovereign default as a bond exchange. In case of default, the sovereign offers a new bond with lower coupon and principal.The debtors accept the offer if the value of the new bonds is higher than the proceedings of the litigation of the sovereign. Both the default decision of the sovereign as well as the exchange offer are modeled endogenously and in closed form. The resulting formulas for bond value and credit spreads are in closed form as well. The analysis yields credit spread curves similar to corporate credit curves: For high risk issuers, i.e.,sovereign with low country wealth relative to debt level,and high litigation costs,the credit spread curves are “hump ”-shaped. Better quality issues exhibit increasing credit spread curves. The numerical analysis with reasonable parameters yields credit spreads of a size compatible to market spreads. A comparison to corporate debt supports the stylized fact that, using the same parameters,corporate debt is less risky than sovereign debt since the threat of liquidation is stronger than the threat of litigation.

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    Bibliographic Info

    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp43.

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    Date of creation: Feb 2002
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    Handle: RePEc:fam:rpseri:rp43

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    Keywords: Sovereign Debt; Debt pricing; Bond Exchange Offers;

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    1. Boot, Arnoud W A & Kanatas, George, 1995. "Rescheduling of Sovereign Debt: Forgiveness, Precommitment, and New Money," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 363-77, May.
    2. Jonathan Eaton, 1991. "Sovereign Debt: A Primer," Boston University - Institute for Economic Development 21, Boston University, Institute for Economic Development.
    3. Hayri, Aydin, 1997. "Debt Relief," CEPR Discussion Papers 1701, C.E.P.R. Discussion Papers.
    4. Bac, Mehmet, 1995. "On the Term Structure of Sovereign-Debt Contracts," Review of International Economics, Wiley Blackwell, vol. 3(2), pages 174-85, June.
    5. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
    6. Kulatilaka, Nalin & Marcus, Alan J., 1987. "A model of strategic default of sovereign debt," Journal of Economic Dynamics and Control, Elsevier, vol. 11(4), pages 483-498, December.
    7. Jeremy I. Bulow & Kenneth Rogoff, 1987. "A Constant Recontracting Model of Sovereign Debt," NBER Working Papers 2088, National Bureau of Economic Research, Inc.
    8. Grossman, Herschel I & Van Huyck, John B, 1988. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," American Economic Review, American Economic Association, vol. 78(5), pages 1088-97, December.
    9. Hayne E. Leland and Klaus Bjerre Toft., 1995. "Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Research Program in Finance Working Papers RPF-259, University of California at Berkeley.
    10. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    11. Pierre Mella-Barral & William R M Perraudin, 1993. "Strategic Debt Service," CEPR Financial Markets Paper 0039, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
    12. Edwards, Sebastian, 1984. "LDC Foreign Borrowing and Default Risk: An Empirical Investigation, 1976-80," American Economic Review, American Economic Association, vol. 74(4), pages 726-34, September.
    13. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 37-68.
    14. Sebastian Edwards, 1983. "LDC's Foreign Borrowing and Default Risk: An Empirical Investigation," NBER Working Papers 1172, National Bureau of Economic Research, Inc.
    15. Andrew Atkeson, 2010. "International lending with moral hazard and risk of repudiation," Levine's Working Paper Archive 200, David K. Levine.
    16. Bulow, Jeremy & Rogoff, Kenneth S., 1989. "A Constant Recontracting Model of Sovereign Debt," Scholarly Articles 12491028, Harvard University Department of Economics.
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    Cited by:
    1. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer, vol. 26(2), pages 161-191, October.

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