COLLATERAL CONSTRAINTS, DEBT MANAGEMENT AND INVESTMENT INCENTIVES WITH A LOW DEFAULT PROBABILITY

Abstract

This paper analyzes the hedging decisions of an emerging economy which is exposed to market risks and whose debt contract is subject to collateral constraints. Within a sovereign debt model with default risk and endogenous collateral, the hedging policy is studied in a market where both futures and non-linear derivatives are available. In developing this model, the paper looks at the cost of sovereign default, financial constraints after default and hedging as an optimal debt managment tool. Finally, the paper presents a contract framework which provides a lower default probability.