Rare Event Risk and Emerging Market Debt with Heterogeneous Beliefs

Abstract:     
We study the equilibrium pricing of a debt contract when the borrower's economy is subject to rare event risk. In a setting
where the lender and the borrower have heterogeneous beliefs about the likelihood of the rare event, we study the risk sharing role of a debt contract that defaults at the occurrence of this event. A higher belief about the default likelihood by the lender compared to the borrower can lead to countercyclical interest rates and credit spreads in non-default times, and to an increase in the borrower's indebtedness in default times, as typically observed in emerging market economies. When calibrating the model to prices in the credit default swap market, we show that heterogeneous beliefs can account for more than 40% of the variation in CDS spreads associated with shocks to the borrower's economy.

Keywords: Rare Event Risk, Debt Contract, Emerging Market, Exchange Economy, Jump-Diffusion Model, Heterogeneous Beliefs, Incomplete Market

JEL Classifications: D51, D52, E43, F34, G12

Working Paper Series