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Sovereign Debt Restructuring: risk management and financial innovation Stavros A. ZENIOS University of Cyprus Senior Fellow, The Wharton School, USA (With Andrea Consiglio and Ashoka Mody)

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Page 1: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Sovereign Debt Restructuring: risk management and financial innovation

Stavros  A.  ZENIOS

University  of  Cyprus

Senior  Fellow,  The  Wharton  School,  USA

(With  Andrea  Consiglio and  AshokaMody)

Page 2: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

The devil is in the tails

www.voxeu.org August 2015

Page 3: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Outline

Tactical vs strategic debt sustainability

Risk management for debt restructuring

Case study of Greece

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Sovereign contingent debt

Page 4: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

The issues in sovereign debt crises

Page 5: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Facts on sovereign debt

Reminders of Hyman Minsky (1919—1996):

Debt is fragile

Page 6: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Tactical vs Strategic debt sustainability

Tactical: Short-term

End of an IMF program, under program conditions

Given projections (wishes) does debt decline?

Strategic: Long-term

Past IMF program

Under market uncertainties

Does debt decline with probability 95%?

Page 7: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

The issues in sovereign debt crises

Risk management has not been part of analysis

Operational models are missing

“Need for development of criteria for “optimal” debt restructuring process”

(Wright 2012, Harvard Business Law Review)

Page 8: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Risk management for debt restructuring

Page 9: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Debt dynamics

Re-finance debt of different maturities

Look at alternative debt stock flows

Risk management for debt restructuring

Page 10: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Risk management for debt restructuring

Page 11: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Scenario dependent debt dynamics

Using Debt-to-GDP ratio

Risk management for debt restructuring

Page 12: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

D is the term structure of debt (multiple issues)

r is the term structure of sovereign rates

NB (and GDP) 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, in print)

Risk management for debt restructuring

Page 13: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Risk management for debt restructuring

DeaR: Debt-at-Risk

At each terminal node:

Conservation of flow at each node:

xmj – nominal value of debt instrument j issued at node m

Page 14: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Risk management for debt restructuring

(Rockafellar and Uryasev 2000)

Conditional Debt-at-Risk

Page 15: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Risk management for debt restructuring

Page 16: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

The issues in sovereign debt crises

Key parameters (Das et al 2012)

Face and market value of bonds or loansInterest rate and coupon (fixed, flexible, step-up, linked)Amortization scheduleCurrency of denominationEnhancements such as embedded options or collateralLegal clauses (CAC, exit consents)

Page 17: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Case  study  of  Greece  

Page 18: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Case study of Greece

Page 19: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Case study of Greece

Page 20: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Case study of Greece

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Maturities

Initial term structure

Page 21: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Case study of Greece: current debt situation

Page 22: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Case study of Greece: IMF projections

Page 23: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Primary surplus 1.5% and improved country growth assuming fiscal multiplier 0.8

Page 24: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Interest rate concessions

Page 25: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Debt extension

Page 26: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Sovereign CoCo:contingent convertible debt

Page 27: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Sovereign CoCo

A sovereign debt instrument with (i) a built-in trigger to allow, but not require, a standstill of payments

for a fixed period of time (ii) that is activated when an indicator breaches a threshold (iii) becomes effective after the sovereign enters a program with IMF (iv)makes the triggered bond senior to subsequently issued debt

Our suggestion: 30-day average CDS spreads exceed 400bp.

Page 28: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

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Page 29: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Ex ante treatment of sovereign risk

Address creditor moral hazard

Deal with “neglected risks”

Contingent contracts

Page 30: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Risk management for debt restructuring with CoCo

Page 31: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Conclusions

The devil is in the tails

Ex post, risk management for sovereign debt

Ex ante, uncertainty part of contingent contract

Page 32: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

Conclusions

No matter how misguided the negotiating tactics of the Greek government might have been,

debt was unsustainable before they came to power.

Page 33: Sovereign Debt Restructuringpolicydialogue.org/files/events/Stavros_PPT.pdf · Sovereign Debt Restructuring: risk management and financial innovation Stavros(A.(ZENIOS University(of(Cyprus

ReferencesConsiglio,  A.    and  Zenios,  S.A.Risk  management  optimization  for  sovereign  debt  restructuringhttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2478380Greek  debt  sustainability:  the  devils  is  in  the  tailshttp://www.voxeu.org/article/greek-­‐debt-­‐sustainability-­‐devil-­‐tails

Consiglio,  A.  and  Mody,  A.  and  Zenios,  S.A.  (in  preparation)Contingent  convertible  bonds  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