Credit Derivatives and Sovereign Debt Crises

The new markets for credit derivatives allow for buying protection on sovereign debt. This paper considers the implications for sovereign debt crises. We show that the availability of credit protection lowers ex-ante debtor moral hazard by allowing a bondholder to improve his bargaining position in negotiations with the sovereign, thus forcing the sovereign to internalize more of the costs of a crisis. Moreover, we find that equilibrium protection does not hinder an efficient resolution of crises. We even identify situations where crisis resolution is improved by facilitating conditionality. We thank Jonathan Eaton, Harry Huizinga, Jose Scheinkman, Eva Terberger, and participants at the Princeton-Cambridge conference at the Bendheim Center of Finance, at the CFS conference on Credit Risk Transfer in Frankfurt, at the Deutsche Bundesbank, at the Tor Vergata conference and at the European Meetings of the Econometrics Society for helpful comments. We thank in particular Pierre-Hugues Verdier for discussions on the legal issues posed by sovereign credit derivatives. Department of Economics, University of Oxford, Manor Road, Oxford OX1 3UQ, UK. Email: [email protected], Department of Economics, Tilburg University, Postbus 90153, 5000 LE Tilburg, The Netherlands. Email: [email protected] (Tilburg) and [email protected] (Cambridge)