Abstract

http://ssrn.com/abstract=242792
 


 



Country Debt Risk: A Stochastic Inter-temporal Optimization Approach


Jerome L. Stein


Brown University - Division of Applied Mathematics; CESifo (Center for Economic Studies and Ifo Institute)

Wendell H. Fleming


Brown University - Division of Applied Mathematics

January 2001

AFA 2001 New Orleans

Abstract:     
Data on the credit rating of bonds issued in the first half of the 1990s suggest that investors in emerging market securities paid little attention to credit risk, or that they were comfortable with the high level of credit risk that they were incurring. The literature in international finance concerning inter-temporal optimization in discrete time makes assumptions that imply certainty equivalence. Example: If the expected productivity of capital is a constant that exceeds the interest rate, investment and debt are maximal. There is a need for a "paradigm shift" that involves greater analytic emphasis on the risks associated with the reliance on short-term debt for otherwise creditworthy borrowers.

Using stochastic optimal control techniques, we develop a paradigm for risk management, with the constraint that there be no default on short-term foreign currency denominated debt. We solve for the constrained optimal investment and external debt in both a finite horizon discrete time and an infinite horizon continuous time context. We thereby derive benchmarks to compare the actual with the constrained optimal debt. The probability of default/rescheduling increases when our constrained optimality conditions are violated.

The main reason for a deviation between the actual debt and the optimal debt is the moral hazard that has been stressed in the literature on crises. The government provides implicit insurance that induces firms to ignore/underemphasize risk. Bubbles tend to occur. However, when the shocks occur, the government cannot fulfill its commitments.

working papers series


Not Available For Download

Date posted: January 12, 2001  

Suggested Citation

Stein, Jerome L. and Fleming, Wendell H., Country Debt Risk: A Stochastic Inter-temporal Optimization Approach (January 2001). AFA 2001 New Orleans. Available at SSRN: http://ssrn.com/abstract=242792

Contact Information

Jerome L. Stein (Contact Author)
Brown University - Division of Applied Mathematics ( email )
Providence, RI 02912
United States
401-863-2143 (Phone)
401-863-1355 (Fax)
CESifo (Center for Economic Studies and Ifo Institute)
Poschinger Str. 5
Munich, DE-81679
Germany
Wendell Fleming
Brown University - Division of Applied Mathematics ( email )
Providence, RI 02912
United States
Feedback to SSRN


Paper statistics
Abstract Views: 633

© 2014 Social Science Electronic Publishing, Inc. All Rights Reserved.  FAQ   Terms of Use   Privacy Policy   Copyright   Contact Us
This page was processed by apollo6 in 0.343 seconds