Risk management optimization for sovereign debt restructuring

Abstract

Debt restructuring is one of the policy tools available for resolving sovereign debt crises and, while unorthodox, it is not uncommon. We propose a scenario analysis for debt sustainability and integrate it with scenario optimization for risk management in restructuring sovereign debt. The scenario dynamics of debt-to-GDP ratio are used to define a tail risk measure, termed "conditional Debt-at-Risk". A multi-period stochastic programming model minimizes the expected cost of debt financing subject to risk limits. It provides an operational model to handle significant aspects of debt restructuring: it collects all debt issues in a common framework, and can include contingent claims, multiple currencies and step-up or linked contractual features. Alternative debt profiles -- obtained by maturity rescheduling, interest payment concessions or nominal value haircuts -- are analyzed for their expected cost-risk tradeoffs. With a suitable re-calculation of the efficient frontier, the risk of debt unsustainability of alternative risk profiles can be ascertained with a given confidence level. The model is applied to Greece sovereign debt crisis analyzing the suitability of various proposals to restore debt sustainability.