Quantitative Properties of Sovereign Default Models: Solution Methods Matter
By J. Hatchondo, Leonardo Martinez, Horacio Sapriza. Social Science Research Network, 2010
146 citations recorded by the source corpus.
We study the sovereign default model that has been used to account for the cyclical behavior of interest rates in emerging market economies. This model is often solved using the discrete state space technique with evenly spaced grid points. We show that this method necessitates a large number of grid points to avoid generating spurious interest rate movements. This makes the discrete state technique significantly more inefficient than using Chebyshev polynomials or cubic spline interpolation to approximate the value functions. We show that the inefficiency of the discrete state space technique is more severe for parameterizations that feature a high sensitivity of the bond price to the borrowing level for the borrowing levels that are observed more frequently in the simulations. In addition, we find that the efficiency of the discrete state space technique can be greatly improved by (i) finding the equilibrium as the limit of the equilibrium of the finite-horizon version of the model, instead of iterating separately on the value and bond price functions and (ii) concentrating grid points in asset levels at which the bond price is more sensitive to the borrowing level and in levels that are observed more often in the model simulations. Our analysis questions the robustness of results in the sovereign default literature and is also relevant for the study of other credit markets.
Subfields: Economics and Econometrics, Finance
View Paper: https://www.semanticscholar.org/paper/b74df5f32760ceee7bc6328f810c2fdee594e160
Citations in the corpus
- Fiscal Rules and the Sovereign Default Premium (2022, unknown): “tives to issue large amounts of debt before defaulting, which would allow for a large increase in consumption (Hatchondo et al., 2014b). Following Hatchondo et al. (2014a), in order to avoid this problem, we assume that the government cannot issue bonds at a price lower than q (the secondary market ”
- Debt Dilution and Sovereign Default Risk (2011, unknown): “Hatchondo et al. (2010) discuss the computation cost of obtaining accurate solutions in models of sovereign default with one-period bonds and Chatterjee and Eyigungor (2009) explain how the computation cost increases when long-duration bonds are assumed.”
- International Reserves and Rollover Risk (2013, unknown): “We solve for the equilibrium of the finite-horizon version of our economy as in Hatchondo et al. (2010). That is, the approximated value and bond price functions correspond to the ones in the first period of a finite-horizon economy with a number of periods large enough that the maximum deviation be”