The emphasis of the Brady Plan on negotiated debt reduction has increased the importance of a proper understanding of the pricing of external debt in secondary markets in any assessment of the feasibility of different debt restructuring schemes. Three major issues are at stake: the impact of debt reduction on the valuation of the claims that remain; how far credit enhancements increase the market value of the corresponding instruments; and the impact of changes in seniority structure due to the newly created claims.

In Discussion Paper No. 415, Stijn Claessens and Research Fellow Sweder van Wijnbergen argue that existing models fall short of providing the necessary consistent approach to secondary market pricing of existing debt and newly-created, partly-enhanced claims. Most existing models neglect the dynamics of secondary market prices under alternative debt reduction strategies, and few are able to provide insights on the value of credit enhancement. Only an explicit modelling of the sources of uncertainty permits an assessment of the impact of different repayment schedules and seniority structures on secondary market prices.

None of the existing models addresses both the impact of debt reduction on the secondary market price and the valuation of credit enhancements, which are of great practical importance in the voluntary debt reduction exercises that form the core of the current Brady initiative. Their voluntary nature implies that the enhanced new debt instruments must have a market value at least as high as the old instruments, but debt relief will reduce the market value of the debt. Official guarantees provide the solution to this dilemma, since they enable the market value to be reduced while retaining the participation of the commercial banks.

Claessens and van Wijnbergen develop a new model to shed light on the determinants of secondary market prices and the likely impacts on valuation of different debt reduction strategies and forms of enhancements. They demonstrate that debt reduction has a substantial impact on the value of remaining claims. They also assess the values of fixed and rolling guarantees, and they find that from the creditors' point of view, rolling guarantees dominate fixed guarantees as a technique of credit enhancement.

They also provide a preliminary assessment of the debt restructuring agreement recently reached between Mexico and its commercial creditors, and they show that the three options offered to Mexico's creditors are not equivalent if the newly- created bonds are senior to the new money option, which explains why only a small proportion of creditors chose the new money option. For the package as a whole, they find that the market value of the new debt instruments, including enhancements, is close to the pre-Brady Plan value of commercial claims on Mexico; but the market value without enhancements went down by almost the complete value of the official enhancements, so that Mexico had negotiated a substantial measure of debt relief.

Secondary Market Prices under Alternative Debt Reduction Strategies: An Option Pricing Approach with an Application to Mexico
Stijn Claessens and Sweder van Wijnbergen

Discussion Paper No. 415, April 1990 (IM)