Sovereign debt: optimal contract, underinvestment, and forgiveness

Article Abstract:

In this paper we develop a time consistent rational expectations model which analyzes the equilibrium loan contract between borrowing country and a foreign bank. The loan contract specifies both the amount of the loan and the promised interest payments, and rationally reflects the investment decisions of the country and the possibilities of renegotiation and repudiation of the debt. An important feature of the model is that at the initial negotiation of the loan there is uncertainty about whether the country will renegotiate for partial forgiveness in the future, and whether it will eventually repudiate the debt, even having successfully renegotiated. Moreover, the probabilities of renegotiation and repudiation, and the amount of possible forgiveness are endogenously determined. In the model of repudiation decision is directly related to the underinvestment problem; the objective of the renegotiation is precisely to alleviate this problem. The model is used to analyze the effects of four variables on both the optimal contract and the country's welfare; the degree of penalties that a bank can impose on a defaulting country, the uncertainty of production, the productivity of investments and the riskless interest rate. The analysis has policy implications as well as testable predictions. (Reprinted by permission of the publisher.)

External debt relief, Debt relief, Rational expectations (Economics), Sovereign debt market

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The stochastic behavior of commodity prices: implications for valuation and hedging

Article Abstract:

In this article we compare three models of the stochastic behavior of commodity prices that take into account mean reversion, in terms of their ability to price existing futures contracts, and their implication with respect to the valuation of other financial and real assets. The first model is a simple one-factor model in which the logarithm of the spot price of the commodity is assumed to follow a mean reverting process. The second model takes into account a second stochastic factor, the convenience yield of the commodity, which is assumed to follow a mean reverting process. Finally, the third model also includes stochastic interest rates. The Kalman filter methodology is used to estimate the parameters of the three models for two commercial commodities, copper and oil, and one precious metal, gold. The analysis reveals strong mean reversion in the commercial commodity prices. Using the estimated parameters, we analyze the implications of the models for the term structure of futures prices and volatilities beyond the observed contracts, and for hedging contracts for future delivery. Finally, we analyze the implications of the models for capital budgeting decisions. (Reprinted by permission of the publisher.)

Analysis, Hedging (Finance), Valuation, Stochastic processes, Commodities

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Stochastic convenience yield and the pricing of oil contingent claims

Article Abstract:

This paper develops and empirically tests a two-factor model for pricing financial and real assets contingent on the price of oil. The factors are the spot price of oil and the instantaneous convenience yield. The parameters of the model are estimated using weekly oil futures contract prices from January 1984 to November 1988, and the model's performance is assessed out of sample by valuing futures contracts over the period November 1988 to May 1989. Finally the model is applied to determine the present values of one barrel of oil deliverable in one to ten years time. (Reprinted by permission of the publisher.)

Pricing, Petroleum

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