Ex-ante implications of sovereign default

Research output: Contribution to journalArticlepeer-review

Abstract

I study how the possibility of default on external debts affects other capital allocation decisions in a small open economy. In the model, default has an option value derived from the randomization over ex-post default regimes, which depends on country-specific productivity shocks. This feature of default reduces incentives for ex-ante diversification, which would reduce exposure to the productivity shock. As a result, if the economys debt to capital ratio is allowed to cross a fixed threshold (identified in the model), the unique equilibrium exhibits an allocation of capital that is less productive in expectation and more volatile than in a benchmark model without default. The model therefore captures a number of salient features of emerging and less developed countries, where low levels of international risk-sharing have gone hand-in-hand with frequent and recurring default events.

Original languageEnglish (US)
Pages (from-to)386-397
Number of pages12
JournalJournal of Banking and Finance
Volume49
DOIs
StatePublished - Dec 1 2014

Keywords

  • Financial integration
  • Option-value
  • Sovereign defaults
  • Threshold effects

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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