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State-contingent debt with lender risk aversion

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  • Pina, Gonçalo

Abstract

State-contingent debt has the potential to eliminate costly debt crises. Yet, markets for this type of debt remain essentially closed. This paper uses a simple model to show conditions under which specialized risk-averse foreign lenders prefer non-contingent debt to state-contingent debt. Borrowers always prefer state-contingent debt as non-contingent debt increases the probability of default and reduces investment and output. However, lenders face a trade-off between the total surplus generated by the investment project and the share that they appropriate through the financial trade. Even though total surplus is smaller with non-contingent debt when compared to state-contingent debt, the share of the surplus that goes to lenders is larger under non-contingent debt. The paper then characterizes environments where state-contingent debt is more likely to be preferred by both borrowers and lenders under risk aversion.

Suggested Citation

  • Pina, Gonçalo, 2024. "State-contingent debt with lender risk aversion," The Quarterly Review of Economics and Finance, Elsevier, vol. 94(C), pages 180-189.
    • Handle: RePEc:eee:quaeco:v:94:y:2024:i:c:p:180-189
    DOI: 10.1016/j.qref.2024.01.009
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    More about this item

    Keywords

    State-contingent debt; Financial innovation; Risk aversion; Sovereign default;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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