IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this paper

Debt dilution and sovereign default risk

  • Leonardo Martinez

    (International Monetary Fund)

  • Cesar Sosa Padilla

    (University of Maryland)

  • Juan Hatchondo

    (Federal Reserve Bank of Richmond)

We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline model `a la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: https://economicdynamics.org/meetpapers/2012/paper_974.pdf
Download Restriction: no

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 974.

as
in new window

Length:
Date of creation: 2012
Date of revision:
Handle: RePEc:red:sed012:974
Contact details of provider: Postal:
Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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


More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Martin Uribe & Vivian Z. Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  2. Sandra Lizarazo, 2009. "Contagion of Financial Crises in Sovereing Debt Markets," Working Papers 0906, Centro de Investigacion Economica, ITAM.
  3. Javier Bianchi, 2011. "Overborrowing and Systemic Externalities in the Business Cycle," American Economic Review, American Economic Association, vol. 101(7), pages 3400-3426, December.
  4. Juan Carlos Hatchondo & Leonardo Martinez & Cesar Sosa-Padilla, 2014. "Debt Dilution and Sovereign Default Risk," Department of Economics Working Papers 2014-06, McMaster University.
  5. Durdu, C. Bora & Nunes, Ricardo & Sapriza, Horacio, 2013. "News and sovereign default risk in small open economies," Journal of International Economics, Elsevier, vol. 91(1), pages 1-17.
  6. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
  7. Kletzer, Kenneth M, 1984. "Asymmetries of Information and LDC Borrowing with Sovereign Risk," Economic Journal, Royal Economic Society, vol. 94(374), pages 287-307, June.
  8. Hatchondo, Juan Carlos & Martinez, Leonardo & Sosa Padilla, César, 2014. "Voluntary sovereign debt exchanges," Journal of Monetary Economics, Elsevier, vol. 61(C), pages 32-50.
  9. Sandra Lizarazo, 2009. "Default Risk and Risk Averse International Investors," Working Papers 0907, Centro de Investigacion Economica, ITAM.
  10. Ceyhun Bora Durdu, 2007. "Quantitative implications of indexed bonds in small open economies," International Finance Discussion Papers 909, Board of Governors of the Federal Reserve System (U.S.).
  11. Igor Livshits & James MacGee & Michele Tertilt, 2003. "Consumer bankruptcy: a fresh start," Working Papers 617, Federal Reserve Bank of Minneapolis.
  12. Emine Boz & Christian Daude & Ceyhun Bora Durdu, 2008. "Emerging market business cycles revisited: learning about the trend," International Finance Discussion Papers 927, Board of Governors of the Federal Reserve System (U.S.).
  13. Dirk Niepelt, 2008. "Debt Maturity without Commitment," CESifo Working Paper Series 2500, CESifo Group Munich.
  14. Hatchondo, Juan Carlos & Martinez, Leonardo, 2009. "Long-duration bonds and sovereign defaults," Journal of International Economics, Elsevier, vol. 79(1), pages 117-125, September.
  15. Martín González-Rozada & EduardoLevy Yeyati, 2008. "Global Factors and Emerging Market Spreads," Economic Journal, Royal Economic Society, vol. 118(533), pages 1917-1936, November.
  16. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
  17. Juan Carlos Hatchondo & Francisco Roch & Leonardo Martinez, 2012. "Fiscal Rules and the Sovereign Default Premium," IMF Working Papers 12/30, International Monetary Fund.
  18. Fishlow, Albert, 1985. "Lessons from the past: capital markets during the 19th century and the interwar period," International Organization, Cambridge University Press, vol. 39(03), pages 383-439, June.
  19. Ugo Panizza & Eduardo Levy Yeyati, 2006. "The Elusive Costs of Sovereign Defaults," Research Department Publications 4485, Inter-American Development Bank, Research Department.
  20. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2013. "Why Do Emerging Economies Borrow Short Term?," Journal of the European Economic Association, European Economic Association, vol. 11, pages 67-100, 01.
  21. Vivian Z. Yue, 2005. "Sovereign Default and Debt Renegotiation," 2005 Meeting Papers 138, Society for Economic Dynamics.
  22. Cristina Arellano, 2008. "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, American Economic Association, vol. 98(3), pages 690-712, June.
  23. Juan M. Sanchez & Horacio Sapriza & Gabriel Cuadra, 2009. "Fiscal Policy and Default Risk in Emerging Markets," 2009 Meeting Papers 701, Society for Economic Dynamics.
  24. Satyajit Chatterjee & Burcu Eyigungor, 2012. "Maturity, Indebtedness, and Default Risk," American Economic Review, American Economic Association, vol. 102(6), pages 2674-99, October.
  25. Per Krusell & Anthony A. Smith, Jr., . "Consumption-Savings Decisions with Quasi-Geometric Discounting," GSIA Working Papers 2001-05, Carnegie Mellon University, Tepper School of Business.
  26. Diego Saravia, 2004. "On the Role and E ects of IMF Seniority," Econometric Society 2004 Latin American Meetings 131, Econometric Society.
  27. Alexander Guembel & Oren Sussman, 2009. "Sovereign Debt without Default Penalties," Review of Economic Studies, Oxford University Press, vol. 76(4), pages 1297-1320.
  28. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  29. Juan J. Cruces & Christoph Trebesch, 2013. "Sovereign Defaults: The Price of Haircuts," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 85-117, July.
  30. Cuadra, Gabriel & Sapriza, Horacio, 2008. "Sovereign default, interest rates and political uncertainty in emerging markets," Journal of International Economics, Elsevier, vol. 76(1), pages 78-88, September.
  31. Guido Sandleris & Horacio Sapriza & Filippo Taddei, 2008. "Indexed Sovereign Debt: An Applied Framework," Carlo Alberto Notebooks 104, Collegio Carlo Alberto, revised 2011.
  32. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 41-61, February.
  33. Mark Aguiar & Gita Gopinath, 2004. "Defaultable debt, interest rates, and the current account," Working Papers 04-5, Federal Reserve Bank of Boston.
  34. Oren Sussman & Alexander Guembel, 2005. "Sovereign Debt Without Default Penalties," OFRC Working Papers Series 2005fe17, Oxford Financial Research Centre.
  35. Bai, Yan & Zhang, Jing, 2012. "Financial integration and international risk sharing," Journal of International Economics, Elsevier, vol. 86(1), pages 17-32.
  36. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2007. "Quantitative models of sovereign default and the threat of financial exclusion," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 251-286.
  37. R. Gelos & Guido Sandleris & Ratna Sahay, 2004. "Sovereign Borrowing by Developing Countries; What Determines Market Access?," IMF Working Papers 04/221, International Monetary Fund.
  38. Eduardo Borensztein & Ugo Panizza, 2009. "The Costs of Sovereign Default," IMF Staff Papers, Palgrave Macmillan, vol. 56(4), pages 683-741, November.
  39. Mark Aguiar & Gita Gopinath, 2004. "Emerging market business cycles: the cycle is the trend," Working Papers 04-4, Federal Reserve Bank of Boston.
  40. Eaton, Jonathan & Fernandez, Raquel, 1995. "Sovereign debt," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 3, pages 2031-2077 Elsevier.
  41. Michael Tomz & Mark L. J. Wright, 2007. "Do Countries Default In "Bad Times"?," CAMA Working Papers 2007-23, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  42. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  43. marina, azzimonti, 2009. "Barriers to investment in polarized societies," MPRA Paper 25936, University Library of Munich, Germany.
  44. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, vol. 7(2), pages 117-161, June.
  45. Jeffrey Sachs & Daniel Cohen, 1982. "LDC Borrowing with Default Risk," NBER Working Papers 0925, National Bureau of Economic Research, Inc.
  46. Juan Jose Cruces & Marcos Buscaglia & Joaquin Alonso, 2002. "The Term Structure of Country Risk and Valuation in Emerging Markets," Working Papers 46, Universidad de San Andres, Departamento de Economia, revised Apr 2002.
  47. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2009. "Heterogeneous Borrowers In Quantitative Models Of Sovereign Default," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 50(4), pages 1129-1151, November.
  48. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & Jose-Victor Rios-Rull, 2007. "A quantitative theory of unsecured consumer credit with risk of default," Working Papers 07-16, Federal Reserve Bank of Philadelphia.
  49. Harold L. Cole & James Dow & William B. English, 1994. "Default, settlement, and signalling: lending resumption in a reputational model of sovereign debt," Staff Report 180, Federal Reserve Bank of Minneapolis.
  50. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Staff Report 410, Federal Reserve Bank of Minneapolis.
  51. David Benjamin & Mark L. J. Wright, 2009. "Recovery Before Redemption: A Theory Of Delays In Sovereign Debt Renegotiations," CAMA Working Papers 2009-15, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  52. Detragiache, Enrica, 1994. "Sensible buybacks of sovereign debt," Journal of Development Economics, Elsevier, vol. 43(2), pages 317-333, April.
  53. Glenn D. Rudebusch & Eric T. Swanson, 2012. "The Bond Premium in a DSGE Model with Long-Run Real and Nominal Risks," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(1), pages 105-43, January.
  54. Paolo Mauro & Marcos Chamon, 2005. "Pricing Growth-Indexed Bonds," IMF Working Papers 05/216, International Monetary Fund.
  55. Emine Boz, 2009. "Sovereign Default, Private Sector Creditors and the IFIs," IMF Working Papers 09/46, International Monetary Fund.
  56. Francis A. Longstaff & Jun Pan & Lasse H. Pedersen & Kenneth J. Singleton, 2011. "How Sovereign Is Sovereign Credit Risk?," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(2), pages 75-103, April.
  57. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
  58. Alfaro, Laura & Kanczuk, Fabio, 2005. "Sovereign debt as a contingent claim: a quantitative approach," Journal of International Economics, Elsevier, vol. 65(2), pages 297-314, March.
  59. Kartik Athreya & Xuan S. Tam & Eric R. Young, 2012. "A Quantitative Theory of Information and Unsecured Credit," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(3), pages 153-83, July.
  60. Jeremy Bulow & Kenneth Rogoff, 1988. "The Buyback Boondoggle," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(2), pages 675-704.
  61. Sosa-Padilla, Cesar, 2012. "Sovereign Defaults and Banking Crises," MPRA Paper 41074, University Library of Munich, Germany.
  62. Enrique G. Mandoza & Vivian Z. Yue, 2008. "A solution to the default risk-business cycle disconnect," International Finance Discussion Papers 924, Board of Governors of the Federal Reserve System (U.S.).
  63. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods matter," Working Paper 10-04, Federal Reserve Bank of Richmond.
  64. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  65. Jeremy Bulow & Kenneth Rogoff, 1991. "Sovereign Debt Repurchases: No Cure for Overhang," The Quarterly Journal of Economics, Oxford University Press, vol. 106(4), pages 1219-1235.
  66. Pablo D'Erasmo & Enrique G. Mendoza, 2016. "Distributional Incentives In An Equilibrium Model Of Domestic Sovereign Default," Journal of the European Economic Association, European Economic Association, vol. 14(1), pages 7-44, 02.
  67. Juan Carlos Hatchondo & Leonardo Martinez & Horacio Sapriza, 2010. "Quantitative properties of sovereign default models: solution methods," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 13(4), pages 919-933, October.
  68. Eduardo Borensztein & Olivier Jeanne & Paolo Mauro & Jeronimo Zettelmeyer & Marcos Chamon, 2005. "Sovereign Debt Structure for Crisis Prevention," IMF Occasional Papers 237, International Monetary Fund.
  69. Nina Budina & Tidiane Kinda & Andrea Schaechter & Anke Weber, 2012. "Fiscal Rules at a Glance; Country Details from a New Dataset," IMF Working Papers 12/273, International Monetary Fund.
  70. Li, Wenli & Sarte, Pierre-Daniel, 2006. "U.S. consumer bankruptcy choice: The importance of general equilibrium effects," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 613-631, April.
  71. Juan Carlos Hatchondo & Leonardo Martinez, 2013. "Sudden Stops, Time Inconsistency, and the Duration of Sovereign Debt," International Economic Journal, Taylor & Francis Journals, vol. 27(2), pages 217-228, June.
  72. Gabriel Cuadra & Horacio Sapriza, 2006. "Sovereign Default, Terms of Trade and Interest Rates in Emerging Markets," Working Papers 2006-01, Banco de México.
  73. 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.
  74. Álvarez-Parra, Fernando & Brandao-Marques, Luis & Toledo, Manuel, 2013. "Durable goods, financial frictions, and business cycles in emerging economies," Journal of Monetary Economics, Elsevier, vol. 60(6), pages 720-736.
  75. Athreya, Kartik B., 2002. "Welfare implications of the Bankruptcy Reform Act of 1999," Journal of Monetary Economics, Elsevier, vol. 49(8), pages 1567-1595, November.
  76. Patrick Bolton & Olivier Jeanne, 2009. "Structuring and Restructuring Sovereign Debt: The Role of Seniority -super-1," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 879-902.
  77. Nina Budina & Andrea Schaechter & Anke Weber & Tidiane Kinda, 2012. "Fiscal Rules in Response to the Crisis; Toward the "Next-Generation" Rules: A New Dataset," IMF Working Papers 12/187, International Monetary Fund.
  78. Enrique G. Mendoza & Vivian Z. Yue, 2012. "A General Equilibrium Model of Sovereign Default and Business Cycles," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 889-946.
  79. Asquith, Paul & Beatty, Anne & Weber, Joseph, 2005. "Performance pricing in bank debt contracts," Journal of Accounting and Economics, Elsevier, vol. 40(1-3), pages 101-128, December.
  80. Mark Aguiar & Manuel Amador, 2013. "Take the Short Route: How to Repay and Restructure Sovereign Debt with Multiple Maturities," NBER Working Papers 19717, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

This item is featured on the following reading lists or Wikipedia pages:

  1. Canadian Macro Study Group

When requesting a correction, please mention this item's handle: RePEc:red:sed012:974. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.