Rare Event Risk and Emerging Market Debt with Heterogeneous Beliefs

Abstract

In a setting where the lender and the borrower have heterogeneous beliefs about the likelihood of a disastrous shock to the borrower's economy, we revisit the debt contract proposed by Barro (2006). We find that a higher belief by the lender compared to the borrower can lead to countercyclical interest rates and credit spreads in non-default times, and to an increase in the borrower's indebtedness in default times, as often observed in emerging market economies. When calibrating the model to prices in the credit default swap market, we show that heterogeneous beliefs can account for more than 40% of the variation in CDS spreads associated with shocks to the borrower's economy in non-default times.

Keywords: Rare Event Risk, Debt Contract, Emerging Market, Exchange Economy, Jump-Diffusion Model, Heterogeneous Beliefs, Incomplete Market

JEL Classification: D51, D52, E43, F34, G12