European Parliament Library

Debt Dilution and Sovereign Default Risk, Leonardo Martinez, Juan Carlos Hatchondo, Cesar Sosa Padilla

We propose a modification to a baseline sovereign default framework that allows us to quantify the importance of debt dilution in accounting for the level and volatility of the interest rate spread paid by sovereigns. We measure the effects of debt dilution by comparing the simulations of the baseline model (with debt dilution) with the ones of the modified model without dilution. We calibrate the baseline model to mimic the mean and standard deviation of the spread, as well as the external debt level, the mean debt duration and a measure of default frequency in the data. We find that, even without commitment to future repayment policies and withoutcontingency of sovereign debt, if the sovereign could eliminate debt dilution, the number of default per 100 years decreases from 3.10 to 0.42. The mean spread decreases from 7.38% to 0.57%. The standard deviation of the spread decreases from 2.45 to 0.72. Default risk falls in part because of a reduction of the level of sovereign debt (36% of the face value and of 11% of the market value). But we show that the most important effect of dilution on default risk results from a shift in the set of government's borrowing opportunities. Our analysis is also relevant for the study of other credit markets where the debt dilution problem could be present
Table Of Contents
Cover Page; Title Page; Copyright Page; Contents; I. Introduction; II. The model; A. The baseline environment; B. Recursive formulation of the baseline framework; C. A model without debt dilution; D. Recursive formulation of the framework without debt dilution; E. Discussion of the framework without debt dilution; III. Results; A. Calibration; 1. Parameter values; 2. Business cycle statistics; B. Simulation results; 1. Menu of combinations of spreads and next-period debt levels; C. Welfare costs of debt-dilution; 2. Consumption compensation
Literary Form
non fiction
Description based upon print version of record
Physical Description
1 online resource (50 p.)
Specific Material Designation
Form Of Item

Library Locations

  • EP Library Luxembourg

    Rue du Fort Thüngen, Luxembourg, L-1313, LU
  • EP Library Brussels

    60 rue Wiertz, Brussels, B-1047, BE
  • EP Library Strasbourg

    7 Place Adrien Zeller, Allée du Printemps, Strasbourg, F-67070, FR