Pricing Rare Event Risk in Emerging Markets

Stephan Dieckmann () and Michael Gallmeyer
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Stephan Dieckmann: W.P. Carey School of Business Arizona State University

No 305, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: This paper solves the pricing problem of an merging market debt contract in which the borrower’s economy is subject to rare event risk. Our model combines elements of a reduced form and a structural model of debt pricing. Rare event risk is modeled as a sudden event in fundamentals, and we study the role of the debt contract in providing risk sharing between the borrower and the lender. The two main frictions under consideration in our equilibrium model are limited participation of the lender through the debt contract, and heterogeneous beliefs between the borrower and the lender about the likelihood of a rare event. We solve for the rate of interest, the credit spread, the risk premium, the write-off (recovery rate) in case of default, and the dynamics of the debt contract in non-default times. We find that limited participation combined with heterogeneous beliefs has strong e®ects on the level and variability of the debt contract properties

Keywords: Rare Event Risk; Emerging Markets; Exchange Economy; Heterogeneous Beliefs; Incomplete Market (search for similar items in EconPapers)
JEL-codes: D51 D52 F34 (search for similar items in EconPapers)
Date: 2006
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