Debt Relief

Abstract

This paper develops a model for pricing sovereign debt under continuous time uncertainty, allowing creditors to carry out debt reductions. Focusing on the sovereign’s willingness to pay rather than on their ability to pay, it models debt reductions as a non-cooperative game. The formulae derived from the model successfully predict the outcomes of the Brady debt relief deals. The model also predicts that the sovereign will get a positive share of the surplus generated by the debt reductions and that the country will be on the ‘wrong’ side of its Debt Laffer curve well before the debt reduction.Brady deals; Continuous-time uncertainty real options; Debt Reduction; Debt Relief