Rare event risk and emerging market debt with heterogeneous beliefs

Stephan Dieckmann and Michael Gallmeyer

Journal of International Money and Finance, 2013, vol. 33, issue C, 163-187

Abstract: In a setting where the lender and the borrower have heterogeneous beliefs about the likelihood of a disastrous shock to the borrower's economy, we study the debt contract that defaults at the occurrence of that shock, as proposed by Barro (2006). We find that a higher belief by the lender compared to the borrower can lead to countercyclical interest rates and credit spreads in non-default times, and to an increase in the borrower's indebtedness in default times, as often observed in emerging market economies. When calibrating the model to prices in the credit default swap market, we show that heterogeneous beliefs can account for more than 40% of the variation in CDS spreads associated with shocks to the borrower's economy in non-default times.

Keywords: Rare event risk; Sovereign debt; Jump-diffusion model; Heterogeneous beliefs; Emerging market (search for similar items in EconPapers)
JEL-codes: D51 D52 E43 F34 G12 (search for similar items in EconPapers)
Date: 2013
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:33:y:2013:i:c:p:163-187

DOI: 10.1016/j.jimonfin.2012.11.017

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