Country Debt Risk: A Stochastic Inter-Temporal Optimization Approach

Posted: 12 Jan 2001

See all articles by Jerome L. Stein

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

Date Written: January 2001

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.

Suggested Citation

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

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

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