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Debt dilution and sovereign default risk

Juan Hatchondo and Leonardo Martinez
Authors registered in the RePEc Author Service: Cesar Sosa-Padilla ()

No 10-08, Working Paper from Federal Reserve Bank of Richmond

Abstract: We measure the effects of debt dilution on sovereign default risk and show how these effects can be mitigated with debt contracts promising borrowing-contingent payments. First, we calibrate a baseline model à la Eaton and Gersovitz (1981) to match features of the data. In this model, bonds' values can be diluted. Second, we present a model in which sovereign bonds contain a covenant promising that after each time the government borrows it pays to the holder of each bond issued in previous periods the difference between the bond market price that would have been observed absent current-period borrowing and the observed market price. This covenant eliminates debt dilution by making the value of each bond independent from future borrowing decisions. We quantify the effects of dilution by comparing the simulations of the model with and without borrowing-contingent payments. We find that dilution accounts for 84% of the default risk in the baseline economy. Similar default risk reductions can be obtained with borrowing-contingent payments that depend only on the bond market price. Using borrowing-contingent payments is welfare enhancing because it reduces the frequency of default episodes.

Keywords: Business cycles; Financial institutions; Financial markets (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cmp and nep-rmg
Date: 2012
References: View references in EconPapers View complete reference list from CitEc
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Related works:
Journal Article: Debt Dilution and Sovereign Default Risk (2016) Downloads
Working Paper: Debt Dilution and Sovereign Default Risk (2015) Downloads
Working Paper: Debt Dilution and Sovereign Default Risk (2014) Downloads
Working Paper: Debt dilution and sovereign default risk (2012) Downloads
Working Paper: Debt Dilution and Sovereign Default Risk (2011) Downloads
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