Ex-ante implications of sovereign default

Samreen Malik

Journal of Banking & Finance, 2014, vol. 49, issue C, 386-397

Abstract: I study how the possibility of default on external debts affects other capital allocation decisions in a small open economy. In the model, default has an option value derived from the randomization over ex-post default regimes, which depends on country-specific productivity shocks. This feature of default reduces incentives for ex-ante diversification, which would reduce exposure to the productivity shock. As a result, if the economys debt to capital ratio is allowed to cross a fixed threshold (identified in the model), the unique equilibrium exhibits an allocation of capital that is less productive in expectation and more volatile than in a benchmark model without default. The model therefore captures a number of salient features of emerging and less developed countries, where low levels of international risk-sharing have gone hand-in-hand with frequent and recurring default events.

Keywords: Sovereign defaults; Option-value; Financial integration; Threshold effects (search for similar items in EconPapers)
JEL-codes: F31 F34 F36 F4 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:49:y:2014:i:c:p:386-397

DOI: 10.1016/j.jbankfin.2014.06.008

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