Valuation of Sovereign Debt with Strategic Defaulting and Rescheduling

Abstract

This paper provides a simple model of the rescheduling of debt following a sovereign default as a bond exchange. In case of default, the sovereign offers a new bond with lower coupon and principal. The debtors accept the offer if the value of the new bonds is higher than the proceedings of the litigation of the sovereign. Both the default decision of the sovereign as well as the exchange offer are modeled endogenously and in closed form. The resulting formulas for bond value and credit spreads are in closed form as well. The analysis yields credit spread curves similar to corporate credit curves: For high risk issuers, i.e., sovereign with low country wealth relative to debt level, and high litigation costs, the credit spread curves are hump-shaped. Better quality issues exhibit increasing credit spread curves. The numerical analysis with reasonable parameters yields credit spreads of a size compatible to market spreads. A comparison to corporate debt supports the stylized fact that, using the same parameters, corporate debt is less risky than sovereign debt since the threat of liquidation is stronger than the threat of litigation.