European Puttable Bonds: An Alternative Instrument for Managing the Sovereign Debt Crisis

Abstract

We propose an alternative instrument for managing the risk of a European sovereign debt crisis that explicitly compensates the insurance guarantor for her risk-sharing activity: European Puttable Bonds (EPBs). EPBs are intended as a temporary and incentive-compatible refinancing instrument, simultaneously facilitating the rollover of sovereign debt, fostering crisis prevention efforts, and reducing the risk of multiple equilibria caused by high government debt levels. The paper's theoretical contribution is threefold: First, we model a financially distressed government's borrowing decision in the context of EPBs. Second, applying option pricing theory, we derive the embedded put option's corresponding strike and equilibrium price. Third, we determine the necessary magnitude of EPBs' conditional coercive measures in equilibrium. The calibration of our model to Portugal's pre-bailout situation in 2010 suggests that very reasonable conditional consumption restrictions (i.e., a reduction of less than 3% of GDP in case sovereign debt exceeds its sustainable limit) are sufficient to decrease expected government indebtedness. In equilibrium, the corresponding insurance premium (put option price) equals about 4% of the puttable bond's notional, which is significantly less than Portugal's accompanied potential savings from lower interest rates.