## Debt Dilution and Sovereign Default Risk

_IMF Working Papers, March 1, 2011_

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## Bibliographic details
- Authors: Leonardo Martinez, Juan Carlos Hatchondo, Cesar Sosa Padilla
- Published: March 1, 2011
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781455227099.001

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### Summary of the paper
- Proposes a modification to a baseline sovereign default framework to quantify the importance of debt dilution for the level and volatility of the interest rate spread paid by sovereigns.
- Compares simulations of the baseline model (with debt dilution) to a modified model without dilution.
- Calibrates the baseline model to mimic:
  - the mean and standard deviation of the spread,
  - the external debt level,
  - the mean debt duration,
  - a measure of default frequency in the data.

### Calibration and methodology
- Approach: simulate a baseline sovereign default model that includes debt dilution and compare with a modified version that eliminates dilution.
- Calibration targets: mean spread, standard deviation of spread, external debt level, mean debt duration, default frequency.

### Key quantitative findings
- Number of defaults per 100 years:
  - with dilution: 3.10
  - without dilution: 0.42
- Mean spread:
  - with dilution: 7.38%
  - without dilution: 0.57%
- Standard deviation of the spread:
  - with dilution: 2.45
  - without dilution: 0.72
- Reduction in the level of sovereign debt when dilution is eliminated:
  - 36% of the face value
  - 11% of the market value

### Mechanisms and interpretation
- Default risk declines partly because eliminating dilution reduces the equilibrium level of sovereign debt (figures above).
- The most important effect of debt dilution on default risk arises from a shift in the set of government's borrowing opportunities when dilution is present versus absent.
- Results are obtained without assuming commitment to future repayment policies and without contingent sovereign debt.
- The analysis is relevant for other credit markets where the debt dilution problem could be present.

### Subject keywords
- Bonds
- Debt default
- Debt dilution
- Public debt
- Sovereign bonds
- Keywords: debt market, interest rate, risk premium, WP

*Leonardo Martinez, Juan Carlos Hatchondo, Cesar Sosa Padilla, Debt Dilution and Sovereign Default Risk (IMF Working Paper No. 2011/070).*

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/debt-dilution-and-sovereign-default-risk-24762_