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A tale of two debt crises: a stochastic optimal control analysis

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  • Stein, Jerome L.

Abstract

Banks should evaluate whether a borrower is likely to default. The author applies several techniques in the extensive mathematical literature of stochastic optimal control/dynamic programming to derive an optimal debt in an environment where there are risks on both the asset and liabilities sides. The vulnerability of the borrowing firm to shocks from either the return to capital, the interest rate or capital gain, increases in proportion to the difference between the Actual and Optimal debt ratio, called the excess debt. As the debt ratio exceeds the optimum, default becomes ever more likely. This paper is A Tale of Two Crises because the analysis is applied to the agricultural debt crisis of the 1980s and to the sub-prime mortgage crisis of 2007. A measure of excess debt is derived, and the author shows that it is an early warning signal of a crisis. --

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Bibliographic Info

Paper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number 2009-44.

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Date of creation: 2009
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Handle: RePEc:zbw:ifwedp:200944

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Keywords: Optimization; banking; stochastic optimal control; agriculture debt crisis; subprime mortgage crisis;

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  1. Jerome L. Stein, 2006. "United States Current Account Deficits: A Stochastic Optimal Control Analysis," CESifo Working Paper Series 1805, CESifo Group Munich.
  2. Blanchet-Scalliet, Christophette & Diop, Awa & Gibson, Rajna & Talay, Denis & Tanre, Etienne, 2007. "Technical analysis compared to mathematical models based methods under parameters mis-specification," Journal of Banking & Finance, Elsevier, Elsevier, vol. 31(5), pages 1351-1373, May.
  3. Stein, Jerome L., 2006. "Stochastic Optimal Control, International Finance, and Debt Crises," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780199280575, October.
  4. Fleming, Wendell H. & Stein, Jerome L., 2004. "Stochastic optimal control, international finance and debt," Journal of Banking & Finance, Elsevier, Elsevier, vol. 28(5), pages 979-996, May.
  5. Jerome L. Stein, 2005. "Optimal Debt And Endogenous Growth In Models Of International Finance," Australian Economic Papers, Wiley Blackwell, Wiley Blackwell, vol. 44(4), pages 389-413, December.
  6. Massimo Guidolin & Elizabeth A. La Jeunesse, 2007. "The decline in the U.S. personal saving rate: is it real and is it a puzzle?," Review, Federal Reserve Bank of St. Louis, issue Nov, pages 491-514.
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Cited by:
  1. Stein, Jerome L., 2011. "The crisis, Fed, Quants and stochastic optimal control," Economic Modelling, Elsevier, Elsevier, vol. 28(1), pages 272-280.

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