Rare Event Risk and Emerging Market Debt with Heterogeneous Beliefs

47 Pages Posted: 17 Feb 2006 Last revised: 31 Aug 2010

See all articles by Stephan Dieckmann

Stephan Dieckmann

University of Pennsylvania - Finance Department

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce

Date Written: December 30, 2009

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

Suggested Citation

Dieckmann, Stephan and Gallmeyer, Michael F., Rare Event Risk and Emerging Market Debt with Heterogeneous Beliefs (December 30, 2009). EFA 2006 Zurich Meetings Paper. Available at SSRN: https://ssrn.com/abstract=883383 or http://dx.doi.org/10.2139/ssrn.883383

Stephan Dieckmann (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

Michael F. Gallmeyer

University of Virginia (UVA) - McIntire School of Commerce ( email )

P.O. Box 400173
Charlottesville, VA 22904-4173
United States
434-243-4043 (Phone)
434-924-7074 (Fax)

HOME PAGE: http://www.commerce.virginia.edu/faculty_research/facultydirectory/Pages/Gallmeyer.aspx

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