Optimal Maturity Structure of Sovereign Debt in Situation of Near Default
44 Pages Posted: 9 Oct 2014
Date Written: September 2014
We study the relationship between default and the maturity structure of the debt portfolio of a Sovereign, under uncertainty. The Sovereign faces a trade-off between a future costly default and a high current fiscal effort. This results into a debt crisis in case a large initial issuance of long term debt is followed by a sequence of negative macro shocks. Prior uncertainty about future fundamentals is then a source of default through its effect on long term interest rates and the optimal debt issuance. Intuitively, the Sovereign chooses a portfolio implying a risk of default because this risk generates a correlation between the future value of long term debt and future fundamentals. Long term debt serves as a hedging instrument against the risk on fundamentals. When expected fundamentals are high, the Sovereign issues a large amount of long term debt, the expected default probability increases, and so does the long term interest rate.
Keywords: Sovereign debt, Debt burden, Default, Financial institutions, Econometric models, Long Term Debt, Maturity Structure, Optimal Default, Rational Expectations, Sovereign Debt Crisis, Uncertainty, debt portfolio, hedging, debt crisis, debt burdens, bonds, sovereign default, hedge, repayment capacity, hedging tool, sovereign bonds, future value, debt contracts, financial markets, derivative, financial fragility, government debt, reserve bank, debt renegotiation, debt crises, state contingent bonds, debt maturity, bond, moral hazard, partial derivative, sovereign debt restructuring, international financial architecture, debt restructuring, hedging instruments, debt management, debt structure, amo
JEL Classification: D84, F34, H63
Suggested Citation: Suggested Citation