Additional Lending upon Default with Endogenous Default Penalty

This paper examines the additional lending decision of a creditor to a sovereign debtor in default. The analysis incorporates the prevalence of partial default and the amount of inherited debt in default. We show that an increase in additional lending, L, could increase the probability of repayment of both the loan outstanding and L, thereby increasing the expected return of L for a given interest rate. Thus, additional lending could be provided at a lower contract interest rate, implying a downward sloping additional loan supply curve. Moreover, we show that over some regions of the additional loan supply schedule the contract interest rate could be below the risk-free rate.