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Risk Management Optimization for Sovereign Debt Restructuring

Debt restructuring is gaining acceptance as a policy tool for resolving sovereign debt crises. In this paper we propose a scenario analysis for debt sustainability and integrate it with scenario optimization for the risk management of re-profiling sovereign debt. The scenario dynamics of debt are used to define a risk metric -- conditional Debt-at-Risk -- for the tail of debt-to-GDP ratios, and a multi-period stochastic programming model optimizes the expected cost of financing a debt structure, subject to limits on the risk. The model handles important technical aspects of debt restructuring: it collects all debt issues in a common framework, and can include embedded options and contingent claims, multiple currencies and step-up or linked contractual features. Alternative debt profiles are then analyzed for their cost vs risk tradeoffs. With a suitable re-calculation of the efficient frontier, debt sustainability of a given debt profile can then be ascertained. The model is applied to two stylized examples drawn from an IMF publication and from the Cyprus debt crisis.