A Balance Sheet Approach for Sovereign Debt

23 Pages Posted: 14 Jan 2011

See all articles by Dan Galai

Dan Galai

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Yoram Landskroner

Hebrew University of Jerusalem - Department of Finance and Banking; New York University (NYU) - Leonard N. Stern School of Business

Alon Raviv

Bar-Ilan University - Graduate School of Business Administration

Zvi Wiener

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Date Written: January 14, 2011

Abstract

A sovereign that is issuing debt denominated in foreign currency is exposed to a mismatch between the value of its assets that can be used to serve the debt, denominated in local currency, and the value of its liability. During economic crisis, when the probability of default by the sovereign increases, there is a tendency for the exchange rate to experience sudden shock. Such a relationship has been observed in most of the recent financial crises in emerging markets (for example, in the East Asian crisis of 1997 and the Russian debt crisis of 1998).

In this paper we develop a structural model for pricing sovereign debt that is denominated in foreign currency where the effect of local economic crisis on the exchange rate is considered through a state-dependent jump intensity variable that is sensitive to the distance of default of the sovereign debt. The presented pricing model can produce a higher credit spread than the classical Merton-based approach (1974) for risky debt. The model can help traders, risk managers, accountants, and policymakers who are interested in more accurately evaluating the fair value of sovereign debt that is denominated in foreign currency.

Keywords: currency crisis, exchange rate, sovereign debt, jump diffusion, asset pricing

JEL Classification: G12, G13, G15

Suggested Citation

Galai, Dan and Landskroner, Yoram and Raviv, Alon and Wiener, Zvi, A Balance Sheet Approach for Sovereign Debt (January 14, 2011). Available at SSRN: https://ssrn.com/abstract=1740253 or http://dx.doi.org/10.2139/ssrn.1740253

Dan Galai

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel
972 2 5883235 (Phone)
972 2 5881341 (Fax)

Yoram Landskroner

Hebrew University of Jerusalem - Department of Finance and Banking ( email )

Mount Scopus
Jerusalem, 91905
Israel

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

Alon Raviv (Contact Author)

Bar-Ilan University - Graduate School of Business Administration ( email )

The Graduate School of Business Administration
Ana and Max Web st
Ramat Gan
Israel

Zvi Wiener

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel
(972)-2-588-3049 (Phone)
(972)-2-588-3105 (Fax)

HOME PAGE: http://pluto.mscc.huji.ac.il/~mswiener/zvi.html

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