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Sovereign Risk and Secondary Markets

  • Fernando Broner
  • Alberto Martin
  • Jaume Ventura

The present paper shows that secondary markets can ameliorate, and sometimes fully solve, problems of sovereign risk in international financial markets. We study two environments. In the first one, private agents can in principle issue a complete set of state-contingent securities but governments cannot commit to make payments or enforce payments by their residents. In the second environment, we introduce an additional friction in that only non-contingent securities can be issued. In the absence of secondary markets, in both cases international risk sharing is impossible since countries never make payments to foreigners ex-post. When we introduce secondary markets by allowing agents to trade securities before governments decide whether to make or enforce payments international risk sharing becomes possible. In the first case, secondary markets lead to the first best. In the second case, secondary markets combined with appropriate public debt policy allow for international risk sharing. The mechanism behind our results is that secondary markets tend to transfer securities from those agents who are less likely to be repaid to those agents who are more likely to be repaid. In particular, agents tend to purchase securities issued by other domestic agents and by the domestic government from foreigners. This role of secondary markets in improving enforcement ex-post seems robust and is likely to apply to other environments

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 565.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:565
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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