Financial Management Association, Nashville, Tennessee, Annual Meeting, 2014
60 Pages Posted: 30 Jun 2015 Last revised: 14 May 2017
Date Written: June 28, 2015
We build a structural credit risk model for an emerging market country which follows a fixed exchange rate regime under a Currency Board Arrangement (CBA). It is assumed that the sovereign has bonds outstanding both in local soft currency (treasuries) and in hard currency (Eurobonds). In such a setting, the liability side of the balance sheet of the country can be viewed as composed of three items in increasing order of seniority -- monetary base, domestic debt, and foreign debt. The foreign debt is the most senior tranche in the capital structure and has a typical payment priority due to the presence of limited foreign exchange reserves. The monetary base is the most junior one and has the characteristics of equity. In pursuing optimal financial and macroeconomic policies, the sovereign affects the fundamental values of the three instruments. We quantify the effects that arise and this allows us to make a thorough macrofinancial diagnostics of the CBA. We discuss further issues related to optimal capital structure, debt issuance and buy-backs, sterilizations, and general financial challenges of conducting macro policy under credit risk and fixed exchange rate. We make an empirical application to a representative set of countries following a CBA.
Keywords: sovereign risk, credit spread, currency spread, foreign debt, domestic debt, Merton model, capital structure, Currency Board
JEL Classification: F30, E43, G12, G15, C58
Suggested Citation: Suggested Citation
Thalassinos, Eleftherios Ioannis and Thalassinos, Pantelis and Yordanov, Vilimir, Currency Board Arrangement Capital Structure Macrofinancial Diagnostics (June 28, 2015). Financial Management Association, Nashville, Tennessee, Annual Meeting, 2014. Available at SSRN: https://ssrn.com/abstract=2624333 or http://dx.doi.org/10.2139/ssrn.2624333