Risky Sovereign Capital Structure: Fundamentals

Abstract

We develop a structural credit risk model for a sovereign issuer with both domestic and foreign debt. The country faces default risk, has either a soft or hard currency, and may be viewed as an emerging market, developed market, or currency union member. Domestic debt consists of local currency bonds (treasuries), while foreign debt is issued internationally in hard currency (Eurobonds). These instruments generate two distinct yield curves, which, when referenced to a risk-free benchmark, give rise to both credit and currency spreads. While the standard Merton model provides a powerful setting to investigate the fundamentals of a single risky yield curve of a corporate issuer, it remains largely unexplored in a cross-currency sovereign setting. We construct a comprehensive framework from scratch to make a thorough structural diagnostics of the two risky spreads. An empirical application is conducted on a set of countries following different exchange rate regimes.

Keywords: capital structure, Merton model, risky sovereign spreads, Modigliani-Miller irrelevance, CCA

JEL Classification: F30, E43, G12, G15, C58