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

_IMF Working Papers, March 12, 2021_

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**Canonical URL:** [Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt](https://www.imf.org/en/publications/wp/issues/2021/03/12/uncertainty-premia-sovereign-default-risk-and-state-contingent-debt-50163)

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## Bibliographic details
- Authors: Francisco Roch, Francisco Roldán
- Published: March 12, 2021
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781513572635.001

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### Research question and framework
- 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).

### Key findings
- 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.

### Implications for debt design and policy
- 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 areas and keywords
- 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

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_Source: https://www.imf.org/en/publications/wp/issues/2021/03/12/uncertainty-premia-sovereign-default-risk-and-state-contingent-debt-50163_