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Ex-ante implications of sovereign default

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  • Malik, Samreen

Abstract

I study how the possibility of default on external debts affects other capital allocation decisions in a small open economy. In the model, default has an option value derived from the randomization over ex-post default regimes, which depends on country-specific productivity shocks. This feature of default reduces incentives for ex-ante diversification, which would reduce exposure to the productivity shock. As a result, if the economys debt to capital ratio is allowed to cross a fixed threshold (identified in the model), the unique equilibrium exhibits an allocation of capital that is less productive in expectation and more volatile than in a benchmark model without default. The model therefore captures a number of salient features of emerging and less developed countries, where low levels of international risk-sharing have gone hand-in-hand with frequent and recurring default events.

Suggested Citation

  • Malik, Samreen, 2014. "Ex-ante implications of sovereign default," Journal of Banking & Finance, Elsevier, vol. 49(C), pages 386-397.
  • Handle: RePEc:eee:jbfina:v:49:y:2014:i:c:p:386-397
    DOI: 10.1016/j.jbankfin.2014.06.008
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    References listed on IDEAS

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    Keywords

    Sovereign defaults; Option-value; Financial integration; Threshold effects;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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