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Maturity structure and Debt renegotiation in Sovereign Bonds

This paper develops a model of endogenous default with debt renegotiation for emerging economies. A small open economy faces a stochastic stream of income. The government can issue short and long term bonds and makes decision on behalf of the residents of the borrowing country. Lenders are risk-neutral and operate in a perfectly competitive financial market. Upon default, the borrowing country loses access to the financial markets and will not be able to borrow any longer. The defaulted country has to pay off the principal and interest of the restructured debt to regain access to the credit market. Debt restructuring is modeled by a Nash bargaining game. The resulted equilibrium haircut is directly related to the debt level. This feature results in a default value function that flattens out after an endogenous threshold; consequently default happens at higher debt levels compared to models without debt renegotiation. The model is calibrated to capture the default episodes in Argentina. The proposed model has several advantages over extant literature. First, the model statistics closely match the observed values. This is particularly the case for the resulted interest rate distributions for short and long term bonds, compared to previous literature. Providing a precise interest rate distribution is crucial as finding the optimal maturity structure relies on it. Furthermore, interest rates can be an indicative of financial crisis. The paper finds that endogenous debt renegotiation is an important mechanism in generating more realistic fluctuations of the interest rate. The proposed model can be used as a policy tool to predict and understand dynamics of financial crises related to debt default.