A Balance Sheet Approach for Sovereign Debt

Dan Galai, Yoram Landskroner, Alon Raviv and Zvi Wiener

Chapter 6 in Bridging the GAAP:Recent Advances in Finance and Accounting, 2012, pp 123-138 from World Scientific Publishing Co. Pte. Ltd.

Abstract: AbstractA sovereign that is issuing debt denominated in foreign currency is exposed to a mismatch between the value of its assets that can be used to service the debt, denominated in local currency, and the value of its liability. During an economic crisis, when the probability of default by the sovereign increases, there is a tendency for the exchange rate to experience sudden shocks. Such a relationship has been observed in most of the recent financial crises in emerging markets (for example, in the East Asian crisis of 1997 and the Russian debt crisis of 1998). In this paper, we develop a structural model for pricing sovereign debt that is denominated in foreign currency, whereby the effect of a local economic crisis on the exchange rate is considered through a state-dependent jump intensity variable that is sensitive to the distance to default of the sovereign debt. The presented pricing model can produce a higher credit spread than the classic Merton-based approach (1974) for risky debt. The model can help traders, risk managers, accountants, and policy makers who are interested in more accurately evaluating the fair value of sovereign debt that is denominated in foreign currency.

Keywords: Finance; Accounting; Fair Value; Asset Prices; Options; Capital Structure; Debt; Inventory; Leverage; Incentive; Specialists; Generally Accepted Accounting Principles (GAAP) (search for similar items in EconPapers)
Date: 2012
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