Long-Duration Bonds and Sovereign Defaults (Revised July 2009)
FRB Richmond Working Paper No. 08-2R
31 Pages Posted: 11 Dec 2012
Date Written: July 21, 2009
Abstract
This paper extends the baseline framework used in recent quantitative studies of sovereign default by assuming that the government can borrow using long-duration bonds. This contrasts with previous studies, which assume the government can borrow using bonds that mature after one quarter. We show that, when we assume that the government issues bonds with a duration similar to the average duration of sovereign bonds in emerging economies, the model generates an interest rate that is substantially higher and more volatile than the one obtained assuming one-quarter bonds. This narrows the gap between the predictions of the model and the data, which indicates that the introduction of long-duration bonds may be a useful tool for future research about emerging economies. Our analysis is also relevant for the study of other credit markets.
Keywords: sovereign default, endogenous borrowing constraints, bond duration, debt dilution, Markov Perfect Equilibrium
JEL Classification: F34, F41
Suggested Citation: Suggested Citation
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