1. Sovereign Debt: Risk management and contingent debt
Andrea Consiglio University of Palermo
Stavros A. Zenios
University of Cyprus
Norwegian School of Economics
Wharton Financial Institutions Center

2. Q1 Is debt sustainable with high probability, say 95%
Q1 Is debt sustainable with high probability, say 95%? Q2 If debt is unsustainable, what debt restructuring schedule will restore sustainability? Q3 What is the optimal debt financing strategy for the sovereign, with or without restructuring? The devil is in the tails Aug. 2015

3. Kingdom of Atlantis debt financing
It is about tradeoffs and assumptions

4. Outline
The debate on sovereign debt restructuring Risk management for debt restructuring Sovereign contingent debt Optimizing stochastic debt sustainability analysis Case study of Greece

5. Ex post: Risk management for debt restructuring
Q1 and Q2. Need stochastic debt sustainability analysis Incorporating risk measures Systematic synthesis of assumptions Q3. Portfolio optimization.

6. Ex ante: Sovereign contingent debt
A sovereign debt instrument with a built-in trigger to allow standstill of payments when a crisis indicator breaches a threshold

7. Debate on sovereign debt restructuring

8. Debate on sovereign debt restructuring
IMF 2013 mea culpa on Greece
“Debt restructurings have often be too little and too late, failing to re-establish debt sustainability and market access in a durable way”
UN General Assembly 2015
Resolution 69/319 on “Basic Principles on Sovereign Debt Restructuring Processes"
(136 in favor, 6 against and 41 abstained)
IMF 2015 declares Greek debt unsustainable

9. Debate on sovereign debt restructuring
Data: Bank of Canada 2014.

10. Debate on sovereign debt restructuring
Data: Trebesch 2011.

11. The issues in sovereign debt crises
To default or not to default?
Eaton-Gersovitz (1981), Krugman (1988), Reinhart-Rogoff (2009), Sturzenegger-Zettelmeyer (2006), Benjamin-Wright (2009), Brunnermeier et al. (2011), De Grauwe (2012)
Is to forgive to forget?
Bulow-Rogoff (1989), Arsanalp-Blaire (2005) Cruces-Trebesch (2013), B-W (above), Wright (2012)
Massive legal problems Krueger (2002), Gianviti et al. (2013), Buchheit et al. (2013),
Delays in resolving crisis destroy value

12. The issues in sovereign debt crises
Endogenously determine debt limit and fiscal space
Mendoza and Oviedo (2009), Blanchard et al. (1990)
Optimal debt financing
Barro (many), Bohn (many), Angelettos (2002), Bolder (2011)
Tradeoffs Missale (1997)
Assumptions
Panizza (in half hour)

13. The issues in sovereign debt crises
What happens if problem is infeasible? Synthesis with sufficient granularity for operations Term structure of legacy debt “Need for development of criteria for “optimal” debt restructuring process” (Wright 2012, Harvard Business Law Review) Risk management has not been part of analysis Operational models are missing

14. Risk management for debt restructuring

15. Risk management for debt restructuring
Debt dynamics
Re-finance debt of different maturities
Look at debt flows
Look at alternative debt structures

16. Risk management for debt restructuring
States and paths determine conditional and unconditional information flow

17. Risk management for debt restructuring
Scenario dependent debt dynamics
D is the term structure of debt (multiple issues)
r is the term structure of sovereign rates
NB can be state-dependent
SF can be state-contingent
Scenario tree integrates economic and financial risk factors
Objective and risk neutral probabilities (Consiglio, Carollo, Zenios, Quantitative Finance, 16: , 2016)

18. Risk management for debt restructuring
Sovereign issues xn(j) nominal value of instrument j at node n

19. Joint Stock and Flow model

20. Risk management for debt restructuring: Flow model

21. Risk measures
Worst case
Risk neutral
Coherent

22. Risk management for debt restructuring: Stock model
Conditional Debt-at-Risk
(Rockafellar and Uryasev 2000)

23. Risk management for debt restructuring: Joint stock and flow model

24. Risk management for debt restructuring: Joint stock and flow constraints
Specifying xn(j)
Fixed mix (simple rules)
Adaptive fixed mix
Stochastic program

25. Risk management for debt restructuring: Endogeneity
𝐶𝐹 𝑗 𝑛,𝑚 =𝚽 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑠, 𝑖𝑛𝑠𝑡𝑟𝑢𝑚𝑒𝑛𝑡 Risk premium 𝑟= 𝑟 𝑓 +𝛒 𝛒:=𝛒 𝑑 𝑟 𝑛 = 𝑟 𝑓 𝑛 +𝛒( 𝑑 𝑛 ) Term premium

26. Risk management for debt restructuring: Endogeneity
𝛒:=𝛒 𝑑

27. The Kingdom of Atlantis

28. The Kingdom of Atlantis

29. The Kingdom of Atlantis
Constant fixed-mix (benchmark) 13.11% of GDP
Adaptive fixed-mix % of GDP
Stochastic program 8.32% of GDP

30. The Kingdom of Atlantis.
Vicious and Virtuous cycles.

31. Case study of Greece

32. Case study of Greece: current debt situation

33. Sovereign contingent debt: From ex post to ex ante solutions

34. Ex ante: Sovereign contingent debt

35. Ex ante treatment of sovereign risk
Address creditor moral hazard
Deal with “neglected risks”
Contingent contracts

36. S-CoCo designs: Trigger
30-day average CDS spread > 300 to 400bp
Country
Trigger
Signed
Program
Early
response
Greece
24 April 2010
5 Sept. 2010
4 months
Portugal
16 Nov. 2010
20 May 2011
6 months
Ireland
1 Oct. 2010
16 Dec. 2010
2,5 months
Spain
27 March 2012
Dec. 2012
9 months
Cyprus
11 July 2011
15 May 2013
21 months

37. S-CoCo Pricing

38. Risk management for debt restructuring with CoCo

39. Conclusions Ex post risk management for sovereign debt
Ex ante deal with uncertainty

40. References
Consiglio, A. and Zenios, S.A Risk management optimization for sovereign debt restructuring Journal of Globalization and Development, (Joseph Stiglitz et al., eds.) Consiglio, A. and Zenios, S.A Contingent convertible bonds for sovereign debt risk management Consiglio, A., Carollo, A. and Zenios, S.A. A parsimonious model for generating arbitrage free scenario trees Quantitative Finance, 16: , 2016.