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Valuation of Sovereign Debt with Strategic Defaulting and Rescheduling

  • Michael WESTPHALEN

    (École des HEC, University of Lausanne and FAME)

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    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.

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    File URL: http://www.swissfinanceinstitute.ch/rp43.pdf
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    Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp43.

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    Date of creation: Feb 2002
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    Handle: RePEc:fam:rpseri:rp43
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    1. Hayri, Aydin, 1997. "Debt Relief," CEPR Discussion Papers 1701, C.E.P.R. Discussion Papers.
    2. Grossman, Herschel I & Van Huyck, John B, 1988. "Sovereign Debt as a Contingent Claim: Excusable Default, Repudiation, and Reputation," American Economic Review, American Economic Association, vol. 78(5), pages 1088-97, December.
    3. Bac, Mehmet, 1995. "On the Term Structure of Sovereign-Debt Contracts," Review of International Economics, Wiley Blackwell, vol. 3(2), pages 174-85, June.
    4. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-78, February.
    5. 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.
    6. Eaton, Jonathan, 1993. "Sovereign Debt: A Primer," World Bank Economic Review, World Bank Group, vol. 7(2), pages 137-72, May.
    7. Atkeson, Andrew, 1991. "International Lending with Moral Hazard and Risk of Repudiation," Econometrica, Econometric Society, vol. 59(4), pages 1069-89, July.
    8. 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.
    9. Pierre Mella-Barral & William R M Perraudin, 1993. "Strategic Debt Service," CEPR Financial Markets Paper 0039, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
    10. 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 363-77, May.
    11. 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.
    12. Sebastian Edwards, 1983. "LDC's Foreign Borrowing and Default Risk: An Empirical Investigation," NBER Working Papers 1172, National Bureau of Economic Research, Inc.
    13. 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.
    14. Edwards, Sebastian, 1984. "LDC Foreign Borrowing and Default Risk: An Empirical Investigation, 1976-80," American Economic Review, American Economic Association, vol. 74(4), pages 726-34, September.
    15. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, vol. 48(2), pages 289-309, April.
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