risk management optimization for sovereign debt restructuring
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Sovereign Debt Restructuring: instruments and risk management models
Stavros A. ZENIOS
University of Cyprus
Senior Fellow, The Wharton School, USA
(Joint work with Andrea Consiglio and Ashoka Mody)
Outline
Some facts about sovereign debt
The issues in sovereign debt crises
Risk management for debt restructuring
Instrument innovations
Case study of Greece
Some facts about sovereign debt
Some facts about sovereign debt
IMF 2013 mea culpa on Greece:
“Debt restructurings have often be too little and too late, thus failing to re-establish debt sustainability and market access in a durable way”
IMF Board 2013
Discuss legal and policy framework for sovereign debt restructuring
UN General Assembly 2014
Negotiate legal framework for sovereign debt restructuring(124 in favor, 11 against, 41 abstain)
Some facts about sovereign debt
Some facts about sovereign debt
Some facts about sovereign debt: Size of IMF programs
Financial Stability Paper No. 27 – November 2013, Sovereign default and state-contingent debt
Martin Brooke, Rhys Mendes, Alex Pienkowski and Eric Santor, Bank of England and Bank of Canada
Observations from the facts
Sovereign debt restructuring is pervasive
Sovereign debt crises are an equal opportunity malaise
Significant amounts involved
Reminders of Hyman Minsky (1919—1996):
Debt is fragile
The issues in sovereign debt crises
The issues in sovereign debt crises
To default or not to default?
Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006),Benjamin-Wright (2009), De Grauwe (2012)
Is to forgive to forget?
Bulow-Rogoff (1989), Arsanalp-Blaire (2005)Cruces-Trebesch (2013), B-W (above), Wright (2012)
Massive legal problems Krueger (2002), Gianviti et al. (2013), Buchheit et al. (2013),
The issues in sovereign debt crises
Operational models are missing
Risk management has not been part of analysis
“Need for development of criteria for “optimal” debt restructuring process”
(Wright 2012, Harvard Business Law Review)
The issues in sovereign debt crises
Key parameters (Das et al 2012)
Face and market value of bonds or loans Interest rate and coupon (fixed, flexible, step-up,
linked) Amortization schedule Currency of denomination Enhancements such as embedded options or collateral Legal clauses (CAC, exit consents)
Risk management for debt restructuring
Debt dynamics
Re-finance debt of different maturities
Look at alternative debt stock flows
Risk management for debt restructuring
Risk management for debt restructuring
Scenario dependent debt dynamics
Formulate using Debt-to-GDP ratio
Risk management for debt restructuring
D is the term structure of debt (multiple issues)
r is the term structure of sovereign rates (or spreads)
GDP, NB can be state-dependent
SF can be state-contingent
Scenario tree integrates economic and financial risk factors
Objective and risk neutral probabilities(Consiglio, Carollo, Zenios, Quantitative Finance, forthcoming)
Risk management for debt restructuring
Risk management for debt restructuring
DEaR: Debt-at-Risk
At each terminal node
Conservation of flow at each node
Risk management for debt restructuring
(Rockafellar and Uryasev 2000)
Conditional Debt-at-Risk
Risk management for debt restructuring
Instrument innovations
Instrument innovations
“Financial optimization makes a good manager better,
and a bad one worse.”
Zenios, S.A., Financial Optimization, Cambridge University press, 1993.
Instrument innovations
QUESTION 1. Is there moral hazard?
YES – Haldane and Scheibe, Bank of England (2004), others NO – IMF (2007)
Creditor vs Debtor moral hazard
“Evidence on moral hazard is not definitive, it is likely that the risk of moral hazard increases as the expected size of official sector support packages rise”
(Brooke et al. Bank of England and Bank of Canada, 2013)
Instrument innovations
QUESTION 2. Are there neglected risks? Are we optimizing under uncertainty or risk?
Gennaioli, Shleifer and Vishny, J. of Financial Economics, 2013
Bermudes and Pardo, Notre Dame J. of Law, Ethics and Public Policy, 2015
Frank H. Knight, Risk, Uncertainty and Profit, 1921.
Sovereign default treated ex poste
Instrument innovations
Ex ante treatment of sovereign risk
CAC – Collective Action Clauses International Capital Markets Association, 2014.
GDP-linked bonds
Kamstra and Shiller, Cowles Foundation, 2009.Borensztein and Paolo Mauro, Economic Policy, 2004.
Sovereign COCOs – Convertible contingent debt
Instrument innovations
Sovereign COCOs – convertible contingent debt
Calomiris and Herring, Journal of Applied Corporate Finance, 2013.Barkbu, Eichengreen, Mody, Journal of International Economics, 2012.
Mody, Oxford Review of Economic Policy, 2013.Brooke et al., Bank of England and Bank of Canada, 2013.
Too big to fail
Too important to fail
Instrument innovations
Features of sovereign COCOs Convert to equity (GDP-linked bond) Delay principal payment Suitable trigger Conversion price
Pricing Triggered by CDS spread Mean-reverting diffusion process with jumps and
autocorrelationsDonoghue et al., International J. of Theoretical and Applied Finance,
2014.
?
Instrument innovations
Case study of Greece
Case study of Greece
Case study of Greece
Case study of Greece: current debt situation
Case study of Greece: IMF projections
Primary surplus 1.5% and improved country growth assuming fiscal multiplier 0.8
Interest rate concessions
Interest rate concessions:extreme frontiers
Debt extension
Risk management for debt restructuring with COCOs
Swap plain vanilla debt instruments by COCOs
Conversion at nominal value
Triggered by CDS spread
Payments delayed by three years
1 2 3 4 5 6 7 8 9 10 11 12 130
20
40
60
80
100
120
1 2 3 4 5 6 7 8 9 10 11 12 130
20
40
60
80
100
120
Triggering the COCO conversion
Difference of trigger variable from threshold
Risk management for debt restructuring with COCOs
Risk management for debt restructuring with COCOs
10 11 12 13 14 15 16 17 18 19245
250
255
260
265
270
275
280
285
No Cocos Cocos 1.2 Cocos 1.4
Conditional Debt at Risk (CDeaR)
Expecte
d c
ost
of
debt
financin
g
Conclusions
Ex post risk management for sovereign debt
Ex ante deal with uncertainty
Interesting conclusions about Greek debt
References
Consiglio, A. and Zenios, S.A.Risk management optimization for sovereign debt restructuringhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2478380
Consiglio, A. and Mody, A. and Zenios, S.A. (in preparation)Contingent debt for sovereign debt risk management
Consiglio, Carollo and Zenios,A parsimonious model for generating arbitrage free scenario trees http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362014
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