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In search of a theory of debt management

  • Faraglia, Elisa
  • Marcet, Albert
  • Scott, Andrew

The complete market approach to government debt management argues that a portfolio of non-contingent bonds at different maturities should be chosen so that fluctuations in market value offset changes in expected future deficits. However, this approach recommends huge fluctuations in positions, enormous changes in portfolios for minor changes in maturities and no presumption it is always optimal to issue long and invest short term in a wide array of model specifications. These extreme, volatile and unstable features are undesirable for two reasons. Firstly fragility of portfolios to small changes in assumptions means that it is often better to follow a balanced budget rather than issue the optimal debt portfolio under some possibly misspecified model. Secondly for even miniscule transaction costs, governments prefer a balanced budget rather than the large positions complete markets recommends. The complete market recommendations conflict with a number of features we believe are integral to bond market incompleteness, e.g. transaction costs, liquidity effects, robustness, etc. and which need to be explicitly incorporated into the portfolio problem.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 57 (2010)
Issue (Month): 7 (October)
Pages: 821-836

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Handle: RePEc:eee:moneco:v:57:y:2010:i:7:p:821-836
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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