Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt

Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt
Author :
Publisher : International Monetary Fund
Total Pages : 38
Release :
ISBN-10 : 9781513572635
ISBN-13 : 1513572636
Rating : 4/5 (636 Downloads)

Book Synopsis Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt by : Mr. Francisco Roch

Download or read book Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt written by Mr. Francisco Roch and published by International Monetary Fund. This book was released on 2021-03-12 with total page 38 pages. Available in PDF, EPUB and Kindle. Book excerpt: We analyze how concerns for model misspecification on the part of international lenders affect the desirability of issuing state-contingent debt instruments in a standard sovereign default model à la Eaton and Gersovitz (1981). We show that for the commonly used threshold state-contingent bond structure (e.g., the GDP-linked bond issued by Argentina in 2005), the model with robustness generates ambiguity premia in bond spreads that can explain most of what the literature has labeled as novelty premium. While the government would be better off with this bond when facing rational expectations lenders, this additional source of premia leads to welfare losses when facing robust lenders. Finally, we characterize the optimal design of the state-contingent bond and show how it varies with the level of robustness. Our findings rationalize the little use of these instruments in practice and shed light on their optimal design.


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