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

March 12, 2021

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Format: Chicago

Francisco Roch, and Francisco Roldán. Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt, (USA: International Monetary Fund, 2021) accessed December 21, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

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.

Subject: Asset prices, Bonds, Debt default, Economic sectors, Economic theory, External debt, Financial crises, Financial institutions, Prices, Public debt, Rational expectations

Keywords: Ambiguity aversion, Ambiguity premia, Asset prices, Bonds, Debt default, Debt structure, Default, Probability distortion, Rational expectations, Robust control, Robust lender, Sovereign debt, State-contingent debt, State-contingent debt instruments, Threshold bond

Publication Details

Pages:

38
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2021/076
Stock No:

WPIEA2021076
ISBN:

9781513572635
ISSN:

1018-5941

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