Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt

IMF Working Papers, March 12, 2021

Source details

Canonical URL: Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt

Examines how concerns for model misspecification by international lenders (robustness/ambiguity aversion) affect the desirability of issuing state-contingent debt instruments.
Uses a standard sovereign default model à la Eaton and Gersovitz (1981).
Focuses on the commonly used threshold state-contingent bond structure (example: the GDP-linked bond issued by Argentina in 2005).

The model with robustness generates ambiguity premia in bond spreads that can explain most of what the literature has labeled as novelty premium.
Under rational expectations lenders, the government would be better off issuing the threshold state-contingent bond.
When facing robust lenders, the additional ambiguity premia lead to welfare losses for the government.
The optimal design of the state-contingent bond varies with the level of robustness (ambiguity aversion) of lenders.
These findings provide a rationale for the limited practical use of state-contingent debt instruments and offer guidance on their optimal design.

State-contingent bonds that appear attractive under rational expectations may become unattractive when lenders distort probabilities due to model misspecification concerns.
Optimal bond design should account for lender robustness: as robustness increases, the bond characteristics that maximize government welfare change.
Policymakers considering state-contingent instruments should weigh potential novelty premia against ambiguity premia priced by robust lenders, because the latter can produce net welfare losses.

Subject: Asset prices, Bonds, Debt default, Economic sectors, Economic theory, External debt, Financial crises, Financial institutions, Prices, Public debt, Rational expectations
Keywords: ambiguity aversion, ambiguity premia, Asset prices, Bonds, Debt default, debt structure, default, probability distortion, Rational expectations, robust control, robust lender, Sovereign debt, State-contingent debt, state-contingent debt instruments, threshold bond