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

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  • Stein, Jerome L.

Abstract

Creditors, banks and bank regulators should evaluate whether a borrower is likely to default. I apply 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 same analysis is applied to the agricultural debt crisis of the 1980s and to the subprime mortgage crisis of 2007. A measure of excess debt is derived, and we show that it is an early warning signal of a crisis in both cases

Suggested Citation

  • Stein, Jerome L., 2010. "A tale of two debt crises: a stochastic optimal control analysis," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 4, pages 1-24.
  • Handle: RePEc:zbw:ifweej:20103
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    File URL: http://dx.doi.org/10.5018/economics-ejournal.ja.2010-3
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    File URL: https://www.econstor.eu/bitstream/10419/29631/1/616556667.pdf
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    References listed on IDEAS

    as
    1. Jerome L. Stein, 2005. "Optimal Debt And Endogenous Growth In Models Of International Finance," Australian Economic Papers, Wiley Blackwell, vol. 44(4), pages 389-413, December.
    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, 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, number 9780199280575.
    4. Stein, Jerome L., 2007. "United States current account deficits: A stochastic optimal control analysis," Journal of Banking & Finance, Elsevier, vol. 31(5), pages 1321-1350, May.
    5. Fleming, Wendell H. & Stein, Jerome L., 2004. "Stochastic optimal control, international finance and debt," Journal of Banking & Finance, Elsevier, vol. 28(5), pages 979-996, May.
    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, vol. 28(1-2), pages 272-280, January.

    More about this item

    Keywords

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

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing

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