Risky Sovereign Capital Structure: Relative Value and Arbitrage

Abstract

We consider a risky country having bonds outstanding both in foreign hard currency (Eurobonds) and local currency (treasuries). This is done under an enhanced structural credit risk Merton-style model. The liability side of the sovereign balance sheet is composed of three tranches in increasing order of seniority: monetary base, domestic debt, and foreign debt. They represent contingent claims on the country’s assets with the monetary base being the equity tranche and the foreign debt, with priority in payment, being the super-senior tranche. The focus of the paper is on the consistency that must hold between their values. Specifically, we try to investigate how the capital structure arbitrage works both in relative value terms and dynamically over the business cycle. The analysis is supported by practical trading strategies and comprehensive empirical applications.

Keywords: capital structure, Merton model, risky sovereign spreads, relative value, arbitrage

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