GDP Linked Bonds: Contract Design and Pricing

Abstract

GDP linked bonds have their cashflows linked to a country's national output. We present a model of sovereign default that tracks the sovereign's capacity to pay through the real exchange rate and potential output. By calibrating to a vanilla bond, our model produces default profiles and prices for GDP linked bonds. We evaluate the model's empirical performance by pricing Argentina's GDP warrants. We then examine the effect on the cost of borrowing and default probability of several indexation schemes and show how our model can identify indexation schemes best suited to countries in different economic circumstances.

Keywords: Sovereign debt, GDP-linked bonds

JEL Classification: F34, G15