Article | Journal of International Economics | March 2005

Sovereign Debt As a Contingent Claim: A Quantitative Approach

by Laura Alfaro and Fabio Kanczuk

Abstract

We construct a dynamic equilibrium model with contingent service and adverse selection to quantitatively study sovereign debt. In the model, benefits of defaulting are tempered by higher future interest rates. For a wide set of parameters, the only equilibrium is one in which the sovereign defaults in all states; additional output losses, however, sustain equilibria that resemble the data. We show that due to the adverse selection problem, some countries choose to delay default to reduce loss of reputation. Moreover, although equilibria with no default imply in greater welfare levels, they are not sustainable in highly indebted and volatile countries.

Keywords: Sovereign Finance; Borrowing and Debt; Interest Rates; Balance and Stability; Risk and Uncertainty; Risk Management; Mathematical Methods; Management Style; Segmentation; Debt Securities; Banking Industry;

Citation:

Alfaro, Laura, and Fabio Kanczuk. "Sovereign Debt As a Contingent Claim: A Quantitative Approach." Journal of International Economics 65, no. 2 (March 2005).