DP8971 The Sovereign Default Puzzle: Modelling Issues and Lessons for Europe

Author(s): Daniel Cohen, Sébastien Villemot
Publication Date: May 2012
Keyword(s): Levy stochastic processes, Sovereign debt
JEL(s): F34
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=8971

Why do countries default? This seemingly simple question has yet to be adequately answered in the literature. Indeed, prevailing modelling strategies compel the to choose between two unappealing model features: depending on the cost of default selected by the modeler, either the debt ratios are too high and the probability of default is too low or the opposite is true. In view of the historical evidence that countries always default after a crisis, we propose a novel approach to the theory of debt default and develop a model that matches the key stylized facts regarding sovereign risk.