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The Case for Contingent Convertible Debt for Sovereignst

Author

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  • Consiglio, Andrea

    (University of Palermo)

  • Zenios, Stavros A.

    (University of Cyprus)

Abstract

This papers makes the case for sovereigns to issue state-contingent convertible bonds(abbreviated S-CoCo) as a means to forestall debt crises. This is a financial innovation response to the lack of sovereign debt restructuring mechanisms. These instruments contractually stipulate payment standstill, contingent on a sovereign's credit default swap spread breaching a distress threshold. They have the advantage of ex ante limiting the likelihood of debt crises, and ex post risk sharing between creditors and the debtor. They are "contingent contracts" addressing problems of "neglected risks" in sovereign debt risk management. Building on literature for state-contingent convertible debt for banks (abbreviated B-CoCo) we address issues pertaining to the design of sovereign contingent debt, including market discipline and sovereign incentives; market manipulation and multiple equilibria; errors of false alarms or missed crises. However, in B-CoCo the conversion is from debt to equity, whereas in S-CoCo the conversion is to more favorable repayment schedule. The paper develops a risk optimization model to incorporate S-CoCo in the portfolio of instruments used to finance a sovereign. The model trades off expected cost vs tail risk. We use Greece as a case study to illustrate Pareto improvements when standstills are contractually possible.

Suggested Citation

  • Consiglio, Andrea & Zenios, Stavros A., 2015. "The Case for Contingent Convertible Debt for Sovereignst," Working Papers 15-13, University of Pennsylvania, Wharton School, Weiss Center.
  • Handle: RePEc:ecl:upafin:15-13
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    File URL: http://fic.wharton.upenn.edu/fic/papers/15/15-13.pdf
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    Cited by:

    1. Consiglio, Andrea & Zenios, Stavros A., 2018. "Pricing and hedging GDP-linked bonds in incomplete markets," Journal of Economic Dynamics and Control, Elsevier, vol. 88(C), pages 137-155.

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