Journal of Banking & Finance Vol. 49 2014
Ex-ante implications of sovereign default
Abstract
I study how the possibility of default on external debts affects other capital allocation decisions in a small open economy. In the model, default has an option value derived from the randomization over ex-post default regimes, which depends on country-specific productivity shocks. This feature of default reduces incentives for ex-ante diversification, which would reduce exposure to the productivity shock. As a result, if the economys debt to capital ratio is allowed to cross a fixed threshold (identified in the model), the unique equilibrium exhibits an allocation of capital that is less productive in expectation and more volatile than in a benchmark model without default. The model therefore captures a number of salient features of emerging and less developed countries, where low levels of international risk-sharing have gone hand-in-hand with frequent and recurring default events.
- DOI
- 10.1016/j.jbankfin.2014.06.008
- Volume
- 49
- Pages
- 386-397
- Language
- en
- Sources
- openalex crossref bibtex:phds-export.bib