Incorporating Creditors' Seniority into Contingent Claim Models: Applicarion to Peripheral Euro Area Countries

Abstract

Institute of Applied Economics (IREA) in Barcelona was founded in 2005, as a research institute in applied economics. Three consolidated research groups make up the institute: AQR, RISK and GiM, and a large number of members are involved in the Institute. IREA focuses on four priority lines of investigation: (i) the quantitative study of regional and urban economic activity and analysis of regional and local economic policies, (ii) study of public economic activity in markets, particularly in the fields of empirical evaluation of privatization, the regulation and competition in the markets of public services using state of industrial economy, (iii) risk analysis in finance and insurance, and (iv) the development of micro and macro econometrics applied for the analysis of economic activity, particularly for quantitative evaluation of public policies. IREA Working Papers often represent preliminary work and are circulated to encourage discussion. Citation of such a paper should account for its provisional character. For that reason, IREA Working Papers may not be reproduced or distributed without the written consent of the author. A revised version may be available directly from the author. Any opinions expressed here are those of the author(s) and not those of IREA. Research published in this series may include views on policy, but the institute itself takes no institutional policy positions.

How quantitative easing changes the nature of sovereign risk

“…Our theoretical framework for sovereign credit risk follows the approach in Jeanneret (2015) and Gómez-Puig et al (2018). 1 For ease of exposition, we assume that the government issues an infinite maturity debt contract that gives creditors a claim on the sovereign's assets A through a constant debt service that is initially set at C. The level of the sovereigns' assets evolves over time according to the following stochastic process:…”

“…Gray et al (2007b) introduce the CCM to sovereign credit risk assessment. Gapen et al (2007), Briire andFerrarini (2016), andGómez-Puig et al (2018) follow similar approaches to derive forward-looking indicators of sovereign risk. Following Gray et al (2007b) we assume that all sovereign assets and liabilities are measured at their current market values.…”

“…Most sovereign debt contracts offer no explicit seniority to a particular group of creditors, however in practice some creditors may have a preferred status. Gómez-Puig et al (2018) argue that multilateral organizations such as the IMF are the most senior lenders. Domestic banks also have a senior status as they typically have substantial investments in domestic government bonds.…”

“…Bonds held by the ECB and other national central banks in the euro area are also senior claims. Bonds however held by the domestic central bank and private investors are junior claims according to Gómez-Puig et al (2018). We follow their approach, except for their treatment of domestic central bank debt as junior claims, taking into account that the the ECB and all national central banks in the euro area have one common credit status.…”