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

Francisco Roch and Francisco Roldán ()
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Francisco Roch: International Monetary Fund

No 47, Working Papers from Red Nacional de Investigadores en Economía (RedNIE)

Abstract: We analyze how concerns for model misspecification on the part of international lenders affect the desirability of issuing state-contingent debt instruments in a stan- dard 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 find- ings rationalize the little use of these instruments in practice and shed light on their optimal design.

Keywords: Sovereign; debt; default; state-contingent; debt; instruments; robust; control; ambiguity; premia (search for similar items in EconPapers)
JEL-codes: E43 E44 F34 G12 H63 O16 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2021-03
New Economics Papers: this item is included in nep-dge, nep-mac and nep-upt
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