Sovereign default risk valuation

Lecture Notes in Economics and Mathematical Systems 582 Founding Editors: M Beckmann H.P Künzi Managing Editors: Prof Dr G Fandel Fachbereich Wirtschaftswissenschaften Fernuniversität Hagen Feithstr 140/AVZ II, 58084 Hagen, Germany Prof Dr W Trockel Institut für Mathematische Wirtschaftsforschung (IMW) Universität Bielefeld Universitätsstr 25, 33615 Bielefeld, Germany Editorial Board: A Basile, A Drexl, H Dawid, K Inderfurth, W Kürsten, U Schittko Jochen Andritzky Sovereign Default Risk Valuation Implications of Debt Crises and Bond Restructurings With 43 Figures and 49 Tables 123 Jochen Andritzky 6432 Divine St McLean, VA 22101 USA jochen@andritzky.com ISBN-10 3-540-37448-5 Springer Berlin Heidelberg New York ISBN-13 978-3-540-37448-0 Springer Berlin Heidelberg New York This work is subject to copyright All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer-Verlag Violations are liable for prosecution under the German Copyright Law Springer is a part of Springer Science+Business Media springeronline.com © Springer Berlin Heidelberg 2006 The use of general descriptive names, registered names, trademarks, etc in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use Typesetting: Camera ready by author Cover: Erich Kirchner, Heidelberg Production: LE-TEX, Jelonek, Schmidt & Vöckler GbR, Leipzig SPIN 11818731 Printed on acid-free paper – 88/3100 – Preface When politics meet economics, history has taught that standard concepts of welfare maximization and efficiency take a back seat And if financial theory by itself were to guide investment decisions, empirical finance could not produce new findings Combine politics and economics, theoretical and empirical finance, and add some spice from dynamically developing markets, and you end up valuing emerging market sovereign bonds The monograph at hand approaches this challenge I am grateful for all the support and advice that I received during this ambitious project First let me thank my advisors at the University of St Gallen, Klaus Spremann and Paul Să oderlind, who oered me the opportunity to join the Swiss Institute for Banking and Finance (s/bf) for fruitful years of research and who supported my academic progress I also thank Kenneth Kletzer and Michael Dooley of the University of California, Santa Cruz, for hosting me as a visiting scholar and providing straightforward advice on my work My research abroad was made possible through the sponsorship of the Swiss National Fund, for which I am most grateful As with most academic studies, this monograph has benefitted greatly from the comments of others Foremost, I thank Manmohan Singh from the International Monetary Fund (IMF) whose good sense of financial markets provided a refreshing antidote to my predominantly theoretical perspective With his input and his extensive contacts among market insiders two joint working papers came into being, thus establishing the basis for Chap Furthermore, I thank Bojan Bistrovic for his thoughts on many mathematical issues A summer spent at the IMF in 2004 became a very fruitful catalyst for my research I would like to thank everyone who made this possible The resulting IMF working paper constitutes an excellent complement VI Preface to this monograph and helped me gauge the fundamental drivers of sovereign bond risk Hence I owe a debt of gratitude to my co-authors, Natalia Tamirisa from the Policy Development and Review Department and Geoffrey Bannister from the International Capital Markets Department, as well as to my advisor Martine Guerguil Many contacts from that time have provided helpful guidance and have given rise to important discussions transcending the scope of this dissertation For their inspiration I would like to thank Axel Bertuch-Samuels, Peter Breuer, Jorge Chan-Lau, Norbert Funke, and Alexander Plekhanov Frank Packer and Haibin Zhu from the Bank for International Settlements contributed valuable comments to Chap Ra´ ul Javaloyes from the UNCTAD gave me helpful insight into debt management tools Alvin Ying from JP Morgan Chase always responded instantly to data requests Profound thanks, too, are due to my colleagues at my home university in Switzerland who not only made the time there so enjoyable but also provided crucial support in the early stages of this project Helpful comments were also received from the conferences of the German Economic Association, the Swiss Society for Financial Market Research, the Irish Economic Association, and the Quant Congress USA, as well as from seminar participants at the universities in St Gallen and Santa Cruz, the IMF, and the Thurgau Institute of Economics For helping me revise this monograph on short notice I wish to thank Veronica Schmiedeskamp, David Kaun, William Koch, and Andrew Verner Words not suffice to describe the support of my wife Juliane During all stages of the dissertation she gave me invaluable emotional backing and helpful advice to steer me through the adversities of a young academic career It was she who always stood by my side and who willingly tolerated never ending working hours St Gallen, January 2006 List of Symbols B C c D d F g h L N P Q q R r S s Y y Z Λ λ ϕ ψ ω τ Value of money market account Coupon payment Annual CDS premium Macauley duration Stochastic discount factor Forward rate Premium leg Protection leg Average life Notional value Risky coupon bond price Cumulative distribution function of the default probability Unconditional default function Recovery adjusted discount rate Instantaneous risk-free rate Survival function Continuous risk spread Annual yield Continuous yield Risky zero bond price Risk-neutral binary hazard rate process Hazard function Total recovery value Recovery fraction of market value (RMV) Recovery fraction of face value (RFV) Credit event time Contents Introduction 1.1 Relevance of the Topic 1.1.1 Relevance for Global Investment 1.1.2 Relevance for Emerging Countries 1.1.3 Relevance in Academic Research 1.2 Research Subject and Methodology 1.2.1 Subject 1.2.2 Methodology 12 1.2.3 Structure 13 Sovereign Lending and Default 2.1 The pre-1990 Episode of Sovereign Lending 2.1.1 Infancy and the “Golden Age” 2.1.2 Bank Loans and Restructuring 2.1.3 The Brady Plan 2.2 The post-1990 Episode of Sovereign Lending 2.2.1 Mexico 1994–1995 2.2.2 The Asian Crisis 1996–1997 2.2.3 Russia 1997–1998 2.2.4 Brazil 1998–1999, 2002–2003 2.2.5 Pakistan 1998–1999 2.2.6 Ecuador 1998–1999 2.2.7 Ukraine 1998–2000 2.2.8 Turkey 2000–2001 2.2.9 Argentina 2000–2005 2.2.10 Uruguay 2001-2003 2.2.11 Moldova 2002 2.2.12 The Caribbean Restructurings 2005–2006 15 17 17 19 21 22 28 29 30 31 32 33 34 35 36 38 39 40 X Contents 2.2.13 Outlook 2.3 The Theory of Sovereign Lending and Default 2.3.1 The Theory of Lending 2.3.2 Crisis Literature 2.3.3 The Literature on the IMF’s Role 2.4 Empirical Evidence 2.4.1 Determinants of Crises 2.4.2 The Effect of IMF Involvement 2.4.3 Determinants of Ratings 2.4.4 Determinants of Spreads 2.5 Concluding Remarks 41 42 43 45 47 49 50 52 54 55 58 Sovereign Restructuring 61 3.1 Literature Review 62 3.1.1 Sovereign Bankruptcy Procedures 62 3.1.2 Analyzing Past Workouts 68 3.2 Crisis Resolution in a Nutshell 69 3.2.1 Liquidity and Solvency Crises 69 3.2.2 Debt Swap, Soft and Hard Restructurings 71 3.3 Evidence From Recent Restructurings 78 3.3.1 Features of Recent Restructurings 80 3.3.2 Resulting Present Value 88 3.4 Lessons for Investors 96 3.4.1 Investor Returns 96 3.4.2 Modeling the Recovery Value 101 3.5 Concluding Remarks 105 Modeling Sovereign Default Risk 109 4.1 Literature Review 110 4.1.1 Structural Models 111 4.1.2 Reduced Form Models 112 4.1.3 Recovery Schemes 116 4.1.4 Outlook 118 4.2 An Overture to Bond Analysis 119 4.2.1 The Money Market Account and the Discount Factor 119 4.2.2 The Price of a Risky Zero Bond 121 4.2.3 The Price of a Risky Coupon Bond 122 4.2.4 Yields, Spot and Forward Rates 124 4.2.5 Default Probability Functions 126 4.2.6 Bootstrap Analysis 127 4.2.7 Bond Duration and Average Life 129 Contents XI 4.3 Functional Forms of the Term Structure 131 4.3.1 Affine Models 132 4.3.2 Parsimonious Models 133 4.3.3 Discussion 141 4.4 Modeling Recovery 143 4.4.1 Recovery of Market Value 144 4.4.2 Mixed Recovery 145 4.4.3 Discussion 146 4.5 Empirical Implementation 147 4.6 Concluding Remarks 150 Empirical Estimations 153 5.1 Empirical Model Comparison 154 5.1.1 The Nelson-Siegel Model 154 5.1.2 Two-factor Nelson-Siegel With RFV 159 5.1.3 The Weibull Model With RFV 163 5.1.4 The Gumbel Model With RFV 168 5.1.5 The Lognormal Model With RFV 171 5.1.6 Discussion 176 5.2 Results From Other Countries 177 5.2.1 Argentina 178 5.2.2 Colombia 183 5.2.3 Mexico 186 5.2.4 Turkey 191 5.2.5 Venezuela 194 5.3 Concluding Remarks 197 Credit Default Swaps 199 6.1 An Introduction to CDS 199 6.1.1 CDS Valuation 202 6.1.2 The CDS Basis 204 6.1.3 The Role of Recovery 206 6.2 Empirical Evidence From Brazil 2002–2003 211 6.2.1 Preliminary Data Analysis 211 6.2.2 No Arbitrage With Two Instruments 214 6.2.3 No Arbitrage With Three Instruments 217 6.3 Concluding Remarks 220 Conclusion 223 References 229 References 239 Edwards, Sebastian (1986), ‘The pricing of bonds and bank loans in international markets: An empirical analysis of developing countries’ foreign borrowing’, European Economic Review 30, 565–589 Edwards, Sebastian (1989), The International Monetary Fund and the developing countries: a critical evaluation, NBER 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Closed-Loop Supply Chain Management X, 150 pages, 2007 (planned) ... better suit the valuation of bonds and credit default swaps (CDS) subject to sovereign risk The short history of sovereign bond markets and the development of ad hoc approaches to sovereign debt... and a general lack of financial data on sovereigns, the pricing of such new instruments requires a profound knowledge of the nature of sovereign default risk, sovereign restructurings, and recovery... borne by a sovereign This distinguishes this study from the large body of literature on corporate default risk However, the concepts of modeling sovereign versus corporate credit risk are related