Forgive, or Award Your Debtor? A Barrier Option Approach

This study presents a model of sovereign debt with an embedded Down-and-In Put (DIP). Our model focuses more on the perspective of a debtor, while taking the creditor's behavior into consideration. The findings suggest that debt forgiveness is more effective than repayment award or default threshold in resolving a sovereign debt crisis. Although changing expectations about both forgiveness and repayment award causes potential debt preservation costs, forgiveness still appears to be a better choice for creditors. Reexamining the argument of Krugman [1988] verifies that extra financing is indeed inferior to forgiveness. The study includes sensitivity and simulation analyses, in addition to empirical investigations based on G20 data. The unscented Kalman filter (UKF) procedure employed is free of potential econometric problems and produces lower forecasting errors than other methods. In addition, the results of UKF are more robust and convincing than those of other variants of the Kalman filter and generalized state space models. As our analysis covers all the major sovereign debt markets, the results contribute much to understanding these issues in sovereign financing