Risky Sovereign Capital Structure: Fundamentals (Part I)
Posted: 5 Nov 2013 Last revised: 30 Apr 2015
Date Written: April 15, 2015
We build a structural credit risk model for a risky sovereign having both domestic and foreign debt outstanding. The country is subject to default risk, has a soft currency, and can be viewed as a small open emerging market economy. The domestic debt is composed of local soft currency denominated bonds (treasuries) and the foreign one is issued internationally in a hard currency (Eurobonds). Both instruments give rise to two yield curves and, if referenced to a riskless benchmark curve, lead to the emergence of a credit and a currency spread. If the standard Merton model provides a powerful setting to investigate the fundamentals of a single risky yield curve of a corporate issuer, the problem is unexplored in a general cross currency situation which is very typical for a sovereign. We develop from scratch a toolkit that allows to make a thorough structural diagnostics of the two risky spreads. An empirical application is made to a set of emerging market countries.
Keywords: capital structure, Merton model, risky sovereign spreads, Modigliani-Miller irrelevance, CCA
JEL Classification: F30, E43, G12, G15, C58
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