Risk management optimization for sovereign debt restructuring

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<p> 1. Sovereign Debt Restructuring: instruments and risk management models Stavros A. ZENIOS University of Cyprus Senior Fellow, The Wharton School, USA (Joint work with Andrea Consiglio and Ashoka Mody) 2. Outline Some facts about sovereign debt The issues in sovereign debt crises Risk management for debt restructuring Instrument innovations Case study of Greece 3. Some facts about sovereign debt 4. Some facts about sovereign debt IMF 2013 mea culpa on Greece: Debt restructurings have often be too little and too late, thus failing to re-establish debt sustainability and market access in a durable way IMF Board 2013 Discuss legal and policy framework for sovereign debt restructuring UN General Assembly 2014 Negotiate legal framework for sovereign debt restructuring (124 in favor, 11 against, 41 abstain) 5. Some facts about sovereign debt 6. Some facts about sovereign debt 7. Some facts about sovereign debt: Size of IMF programs Financial Stability Paper No. 27 November 2013, Sovereign default and state-contingent debt Martin Brooke, Rhys Mendes, Alex Pienkowski and Eric Santor, Bank of England and Bank of Canada 8. Observations from the facts Sovereign debt restructuring is pervasive Sovereign debt crises are an equal opportunity malaise Significant amounts involved Reminders of Hyman Minsky (19191996): Debt is fragile 9. The issues in sovereign debt crises 10. 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), 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), 11. The issues in sovereign debt crises Operational models are missing Risk management has not been part of analysis Need for development of criteria for optimal debt restructuring process (Wright 2012, Harvard Business Law Review) 12. The issues in sovereign debt crises Key parameters (Das et al 2012) Face and market value of bonds or loans Interest rate and coupon (fixed, flexible, step-up, linked) Amortization schedule Currency of denomination Enhancements such as embedded options or collateral Legal clauses (CAC, exit consents) 13. Risk management for debt restructuring 14. Debt dynamics Re-finance debt of different maturities Look at alternative debt stock flows Risk management for debt restructuring 15. Risk management for debt restructuring 16. Scenario dependent debt dynamics Formulate using Debt-to-GDP ratio Risk management for debt restructuring 17. D is the term structure of debt (multiple issues) r is the term structure of sovereign rates (or spreads) GDP, 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, forthcoming) Risk management for debt restructuring 18. Risk management for debt restructuring DEaR: Debt-at-Risk At each terminal node Conservation of flow at each node 19. Risk management for debt restructuring (Rockafellar and Uryasev 2000) Conditional Debt-at-Risk 20. Risk management for debt restructuring 21. Instrument innovations 22. Instrument innovations Financial optimization makes a good manager better, and a bad one worse. Zenios, S.A., Financial Optimization, Cambridge University press, 1993. 23. Instrument innovations QUESTION 1. Is there moral hazard? YES Haldane and Scheibe, Bank of England (2004), others NO IMF (2007) Creditor vs Debtor moral hazard Evidence on moral hazard is not definitive, it is likely that the risk of moral hazard increases as the expected size of official sector support packages rise (Brooke et al. Bank of England and Bank of Canada, 2013) 24. Instrument innovations QUESTION 2. Are there neglected risks? Are we optimizing under uncertainty or risk? Gennaioli, Shleifer and Vishny, J. of Financial Economics, 2013 Bermudes and Pardo, Notre Dame J. of Law, Ethics and Public Policy, 2015 Frank H. Knight, Risk, Uncertainty and Profit, 1921. Sovereign default treated ex poste 25. Instrument innovations Ex ante treatment of sovereign risk CAC Collective Action Clauses International Capital Markets Association, 2014. GDP-linked bonds Kamstra and Shiller, Cowles Foundation, 2009. Borensztein and Paolo Mauro, Economic Policy, 2004. Sovereign COCOs Convertible contingent debt 26. Instrument innovations Sovereign COCOs convertible contingent debt Calomiris and Herring, Journal of Applied Corporate Finance, 2013. Barkbu, Eichengreen, Mody, Journal of International Economics, 2012. Mody, Oxford Review of Economic Policy, 2013. Brooke et al., Bank of England and Bank of Canada, 2013. Too big to fail Too important to fail 27. Instrument innovations Features of sovereign COCOs Convert to equity (GDP-linked bond) Delay principal payment Suitable trigger Conversion price Pricing Triggered by CDS spread Mean-reverting diffusion process with jumps and autocorrelations Donoghue et al., International J. of Theoretical and Applied Finance, 2014. ? 28. Instrument innovations 29. Case study of Greece 30. Case study of Greece 31. Case study of Greece 32. Case study of Greece: current debt situation 33. Case study of Greece: IMF projections 34. Primary surplus 1.5% and improved country growth assuming fiscal multiplier 0.8 35. Interest rate concessions 36. Interest rate concessions: extreme frontiers 37. Debt extension 38. Risk management for debt restructuring with COCOs Swap plain vanilla debt instruments by COCOs Conversion at nominal value Triggered by CDS spread Payments delayed by three years 39. 0 20 40 60 80 100 120 1 2 3 4 5 6 7 8 9 10 11 12 13 0 20 40 60 80 100 120 1 2 3 4 5 6 7 8 9 10 11 12 13 40. Triggering the COCO conversion dn Difference of trigger variable from threshold 41. Risk management for debt restructuring with COCOs 42. Risk management for debt restructuring with COCOs 245 250 255 260 265 270 275 280 285 10 11 12 13 14 15 16 17 18 19 Expectedcostofdebtfinancing Conditional Debt at Risk (CDeaR) No Cocos Cocos 1.2 Cocos 1.4 43. Conclusions Ex post risk management for sovereign debt Ex ante deal with uncertainty Interesting conclusions about Greek debt 44. References Consiglio, A. and Zenios, S.A. Risk management optimization for sovereign debt restructuring http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2478380 Consiglio, A. and Mody, A. and Zenios, S.A. (in preparation) Contingent debt for sovereign debt risk management Consiglio, Carollo and Zenios, A parsimonious model for generating arbitrage free scenario trees http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2362014 </p>

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