Credit Derivatives and Sovereign Debt Crises

Credit derivatives allow for buying protection on corporate debt, but also on sovereign debt. In this paper we examine the implications for sovereign debt crises. We show that the availability of credit protection lowers ex-ante debtor moral hazard by allowing a bondholder to improve his bargaining position in negotiations with the sovereign, thus forcing the sovereign to internalize more of the costs of a crisis. When bondholders use credit protection strategically, we additionally find that credit derivatives do not hinder an efficient resolution of crises. Crisis resolution may even be improved by facilitating conditionality. When protection is not chosen strategically, however, credit protection may also be detrimental to crisis resolution by making restructuring more difficult. In either case we identify a role for government policy as bondholders' choice of protection is not necessarily socially efficient.