Credit Derivatives and Sovereign Debt Crises

Goderis, Benedikt and Wagner, Wolf (2009): Credit Derivatives and Sovereign Debt Crises.

Abstract

Credit derivatives allow for buying protection on corporate debt, but also on sovereign debt. In this paper we examine the implications for sovereign debt crises. We show that the availability of credit protection lowers ex-ante debtor moral hazard by allowing a bondholder to improve his bargaining position in negotiations with the sovereign, thus forcing the sovereign to internalize more of the costs of a crisis. When bondholders use credit protection strategically, we additionally find that credit derivatives do not hinder an efficient resolution of crises. Crisis resolution may even be improved by facilitating conditionality. When protection is not chosen strategically, however, credit protection may also be detrimental to crisis resolution by making restructuring more difficult. In either case we identify a role for government policy as bondholders' choice of protection is not necessarily socially efficient.

• Item Type: MPRA Paper
• Language: English
• Keywords: credit derivatives, sovereign debt crisis, moral hazard
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency ; Event Studies ; Insider Trading; F - International Economics > F3 - International Finance > F34 - International Lending and Debt Problems; F - International Economics > F3 - International Finance > F33 - International Monetary Arrangements and Institutions

References

[1] Arping, S.: 2005, Credit Protection and Lending Relationships. mimeo, University of Amsterdam.

[2] Bank for International Settlements (Basel Committee on Banking Supervision): November 2008, OTC derivatives market activity in the first half of 2008.

[3] Bolton, P. and O. Jeanne: 2005, Structuring and Restructuring Sovereign Debt: The Role of Seniority. NBER working paper no. 11071.

[4] Bulow, J. and K. Rogoff: 1989, Sovereign Debt: Is to Forgive to Forget?. American Economic Review 79, 43-50.

[5] Chiesa, G. : 2008, Optimal credit risk transfer, monitored finance, and banks. Journal of Financial Intermediation 17, 464-477.

[6] Cossin, D. and G. Jung: 2005, Do Major Financial Crises Provide Information on Sovereign Risk to the Rest of the World? A Look at Credit Default Swap Markets. mimeo, HEC Lausanne.

[7] de Brun, J. and U. Della Mea: 2003, Una Aproximación de Mercado a la Reestructuración de la Deuda Soberana: Lecciones de la Experiencia Uruguaya. Revista de Economia 10, 97-142.

[8] Dooley, M.: 2000, Can Output Losses Following International Financial Crises Be Avoided?. NBER working paper no. 7531.

[9] Duffee, G. R. and C. Zhou: 2001, Credit Derivatives in Banking: Useful Tools for Managing Risk?. Journal of Monetary Economics 48, 25-54.

[10] Eaton, J. and M. Gersovitz: 1981, Debt with Potential Repudiation: Theoretical and Empirical Analysis. Review of Economic Studies 48, 289-309.

[11] Eichengreen, B.: 2003, Restructuring Sovereign Debt. Journal of Economic Perspectives 17, 75-98.

[12] Faulkender, M.: 2005, Hedging or Market Timing? Selecting the Interest Rate Exposure of Corporate Debt. Journal of Finance 60, 931-962.

[13] Federal Reserve Bank of New York: 2005, An Overview of the Emerging Market Credit Derivatives Market.

[14] Gai, P., S. Hayes, and H. S. Shin: 2004, Crisis Costs and Debtor Discipline: The Efficacy of Public Policy in Sovereign Debt Crises. Journal of International Economics 62, 245-262.

[15] Gelpern, A. and M. Gulati: forthcoming 2007, Public Symbol in Private Contract: A Case Study. Washington University Law Quarterly.

[16] Ghosal, S. and M. Miller: 2003, Co-Ordination Failure, Moral Hazard and Sovereign Bankruptcy Procedures. The Economic Journal 113, 276-304.

[17] Haldane, A. G., A. Penalver, V. Saporta, and H. S. Shin: 2005, Analytics of Sovereign Debt Restructuring. Journal of International Economics 65, 315-333.

[18] International Association of Restructuring, Insolvency, and Bankruptcy Professionals (INSOL): 2006, �Credit Derivatives in Restructurings; A Guidance Booklet. available online at http://www.insol.org

[19] International Monetary Fund: 2006, Report of the Managing Director to the International Monetary and Financial Committee on the IMF's Policy Agenda. April 2006.

[20] International Swaps and Derivatives Association: 2008, ISDA 2008 Operations Benchmarking Survey.

[21] Jeanne, O.: 2001, Sovereign Debt Crises and the International Financial Architecture. mimeo, IMF.

[22] Kiff, J., F.-L. Michaud, and J. Mitchell: 2003, An Analytical Review of Credit Risk Transfer Instruments. Banque de France FSR pp. 106-131.

[23] Krueger, A.: 2002, New Approaches to Sovereign Debt Restructuring: An Update on our Thinking. Address before the Institute of International Economics (April 1, 2002).

[24] Morrison, A. D.: 2005, Credit Derivatives, Disintermediation and Investment Decisions. Journal of Business 78, 621-648.

[25] Packer, F. and C. Suthiphongchai: 2003, Sovereign Credit Default Swaps. Bank for International Settlements Quarterly Review pp. 79-88.

[26] Pan, J. and K. Singleton: 2005, Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads. mimeo, Stanford University.

[27] Powell, A.. and L. Arozamena: 2003, Liquidity protection versus moral hazard: the role of the IMF. Journal of International Money and Finance 22, 1041-1063.

[28] Ranciere, R. G.: 2001, Credit Derivatives in Emerging Markets. IMF Policy Discussion Paper.

[29] Shleifer, A.: 2003, Will the Sovereign Debt Market Survive?. American Economic Review 93, 85-90.

[30] Spiegel, M. M.: 2005, Solvency Runs, Sunspot Runs, and International Bailout. Journal of International Economics 65, 203-219.

[31] Tirole, J.: 2002, Financial Crises, Liquidity, and the International Monetary System. Princeton: Princeton University Press.

[32] Verdier, P.-H.: 2004, Credit Derivatives and the Sovereign Debt Restructuring Process. mimeo, Harvard Law School.

[33] Weinschelbaum, F. and J. Wynne: 2005, Renegotiation, Collective Action Clauses and Sovereign Debt Markets. Journal of International Economics 67, 47-72.