Sovereign Debt Renegotiation and Credit Default Swaps

A credit default swap (CDS) contract provides insurance against default. After a country defaults, the country and its lenders usually negotiate over the share of the defaulted debt to be repaid. This paper incorporates CDS contracts into a sovereign default model and demonstrates that the existence of a CDS market results in lower default probability, higher debt levels, and lower nancing costs for the country. Since the CDS payout is not automatically triggered by losses from renegotiations, the lender needs to be compensated for lower expected insurance payments. This leads to higher debt repayment in renegotiation, decreasing the bene ts of defaulting, and hence allowing the country to borrow more at lower rates. Uncertainty over the insurance payout when the debt is renegotiated also explains the price discrepancy between CDS and bonds. Furthermore, this pricing dynamic during a debt crisis can be used to infer market perceptions of the probability of the CDS paying out after a renegotiation. To quantitatively illustrate the above e ects, the model is calibrated to Greek data and the results show that increasing CDS levels from 0 to 5% of debt lowers the unconditional default probability from 2.6% to 2.0% per year with no impact on debt level. Further increasing the CDS to 40% of debt increases the equilibrium debt level by 15%. ∗For the most up to date version please visit http://www.stanford.edu/~jsalomao/ I am deeply indebted to Martin Schneider, Manuel Amador, Pablo Kurlat and Monika Piazzesi for their support and guidance through this journey. I also thank participants at the Stanford Macroeconomics Lunch and Finance Reading Group. Support from Kohlhagen Fellowship Fund and the Haley-Shaw Fellowship Fund of the Stanford Institute for Economic Policy Research (SIEPR) is gratefully acknowledged. Correspondence: Department of Economics, Stanford University. 579 Serra Mall, Stanford, CA, 94305. Email: [email protected]