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Valuation of Sovereign Debt with Strategic Defaulting and Rescheduling


  • Michael WESTPHALEN

    (École des HEC, University of Lausanne and FAME)


This paper provides a simple model of the rescheduling of debt following a sovereign default as a bond exchange. In case of default, the sovereign offers a new bond with lower coupon and principal.The debtors accept the offer if the value of the new bonds is higher than the proceedings of the litigation of the sovereign. Both the default decision of the sovereign as well as the exchange offer are modeled endogenously and in closed form. The resulting formulas for bond value and credit spreads are in closed form as well. The analysis yields credit spread curves similar to corporate credit curves: For high risk issuers, i.e.,sovereign with low country wealth relative to debt level,and high litigation costs,the credit spread curves are “hump ”-shaped. Better quality issues exhibit increasing credit spread curves. The numerical analysis with reasonable parameters yields credit spreads of a size compatible to market spreads. A comparison to corporate debt supports the stylized fact that, using the same parameters,corporate debt is less risky than sovereign debt since the threat of liquidation is stronger than the threat of litigation.

Suggested Citation

  • Michael WESTPHALEN, 2002. "Valuation of Sovereign Debt with Strategic Defaulting and Rescheduling," FAME Research Paper Series rp43, International Center for Financial Asset Management and Engineering.
  • Handle: RePEc:fam:rpseri:rp43

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    References listed on IDEAS

    1. Kulatilaka, Nalin & Marcus, Alan J., 1987. "A model of strategic default of sovereign debt," Journal of Economic Dynamics and Control, Elsevier, vol. 11(4), pages 483-498, December.
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    3. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-1089, July.
    4. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
    5. Mella-Barral, Pierre & Perraudin, William, 1997. " Strategic Debt Service," Journal of Finance, American Finance Association, vol. 52(2), pages 531-556, June.
    6. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-178, February.
    7. Leland, Hayne E & Toft, Klaus Bjerre, 1996. " Optimal Capital Structure, Endogenous Bankruptcy, and the Term Structure of Credit Spreads," Journal of Finance, American Finance Association, vol. 51(3), pages 987-1019, July.
    8. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
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    13. Edwards, Sebastian, 1984. "LDC Foreign Borrowing and Default Risk: An Empirical Investigation, 1976-80," American Economic Review, American Economic Association, vol. 74(4), pages 726-734, September.
    14. Anderson, Ronald W & Sundaresan, Suresh, 1996. "Design and Valuation of Debt Contracts," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 37-68.
    15. Boot, Arnoud W A & Kanatas, George, 1995. "Rescheduling of Sovereign Debt: Forgiveness, Precommitment, and New Money," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 363-377, May.
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    Cited by:

    1. Han-Hsing Lee & Kuanyu Shih & Kehluh Wang, 2016. "Measuring sovereign credit risk using a structural model approach," Review of Quantitative Finance and Accounting, Springer, vol. 47(4), pages 1097-1128, November.
    2. Linda Allen & Anthony Saunders, 2004. "Incorporating Systemic Influences Into Risk Measurements: A Survey of the Literature," Journal of Financial Services Research, Springer;Western Finance Association, vol. 26(2), pages 161-191, October.

    More about this item


    Sovereign Debt; Debt pricing; Bond Exchange Offers;

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation


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