GDP Linked Bonds: Contract Design and Pricing

In this paper we analyse the comparative pricing of vanilla and GDP linkedsovereign debt. The key feature of GDP linked bonds is that their cashflowscoupons,principal or both-are linked to the evolution of the country’s nationalincome. While it has long been argued that indexing debt to national outputcould be beneficial for emerging market countries, few models for pricing andanalysing such debt have been proposed. We present a simple structural modelof sovereign default that models the evolution of the sovereign’s capacity to paythrough observable macroeconomic variables. The model allows us to obtainprices and default profiles for vanilla bonds and various GDP linked structuresthat could be issued by emerging market sovereigns. We study four types ofgrowth linked bonds: their default term structures, cash flow profiles, pricingunder different assumptions about investor risk aversion and behaviour againstan assortment of macroeconomic environments. The form chosen for indexationappears to be of paramount importance....