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Designing GDP-Linked Bonds with Default

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  2. Economics, Finance, Business & Management
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  4. Vol. 67, Issue 4
  5. pp. 311–335

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Leventides, J., Melas, E., Poulios, C., Boufounou, P., Leventides, R. Designing GDP-Linked Bonds with Default. Applied Economics Quarterly, 67(4), 311-335. https://doi.org/10.3790/aeq.67.4.311
Leventides, John; Melas, Evangelos; Poulios, Costas; Boufounou, Paraskevi and Leventides, Rena Artemis "Designing GDP-Linked Bonds with Default" Applied Economics Quarterly 67.4, 2021, 311-335. https://doi.org/10.3790/aeq.67.4.311
Leventides, John/Melas, Evangelos/Poulios, Costas/Boufounou, Paraskevi/Leventides, Rena Artemis (2021): Designing GDP-Linked Bonds with Default, in: Applied Economics Quarterly, vol. 67, iss. 4, 311-335, [online] https://doi.org/10.3790/aeq.67.4.311
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Designing GDP-Linked Bonds with Default

Leventides, John | Melas, Evangelos | Poulios, Costas | Boufounou, Paraskevi | Leventides, Rena Artemis

Applied Economics Quarterly, Vol. 67 (2021), Iss. 4 : pp. 311–335

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Article Details

Publisher Name
Duncker & Humblot
DOI
https://doi.org/10.3790/aeq.67.4.311
Language
English
Pages
25
Keywords

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Author Details

John Leventides, Department of Economics, National and Kapodistrian University of Athens, 1 Sofokleous Str. 10559, Athens, Greece.

Evangelos Melas, Department of Economics, National and Kapodistrian University of Athens, 1 Sofokleous Str. 10559, Athens, Greece.

Costas Poulios, Corresponding author. Department of Economics, Faculty of Economics and Political Sciences, National and Kapodistrian University of Athens, 1 Sofokleous Str. 10559, Athens, Greece.

Paraskevi Boufounou, Department of Economics, National and Kapodistrian University of Athens, 1 Sofokleous Str. 10559, Athens, Greece.

Rena Artemis Leventides, Department of Economics, National and Kapodistrian University of Athens, 1 Sofokleous Str. 10559, Athens, Greece

References

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  3. Benford, J./Best, T./Joy, M. (2016): “Sovereign GDP-linked bonds”, Financial Stability Paper No. 39, Bank of England, (with contributions from M. Kruger, Bank of Canada, and the Research Department, Central Bank of Argentina).  Google Scholar
  4. Benford, J./Eguren-Martin, F. (2018): “Sovereign GDP-linked bonds: Pros and cons”, in: Sovereign GDP-Linked Bonds: Rationale and Design, ed. by Shiller, R./Ostry, J./Benford, J., 21–28, a VoxEU.org eBook, Centre for Economic Policy Research (CEPR) Press, London, UK.  Google Scholar
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  6. Bhandari, A./Evans, D./Golosov, M./Sargent, T. J. (2021): “Inequality, Bysiness Cycles, and Monetary-Fiscal Policy”, Econometrica 89, 2559–2599.  Google Scholar
  7. Blanchard, O./Mauro, P./Acalin, J. (2016): “The case for growth-indexed bonds in advanced economies today”, Policy Brief No. PB16-2, Peterson Institute for International Economics (PIIE).  Google Scholar
  8. Bocola, L./Dovis, A. (2019): “Self-Fulfilling Debt Crises: A Quantitative Analysis”, American Economic Review 109, 4343–4377.  Google Scholar
  9. Bohn, H. (1988): “Why do we have nominal government debt?”, Journal of Monetary Economics 21, 127–140.  Google Scholar
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  11. Cabrillac, B./Gauvin, L./Gosse, J.-L. (2016): “GDP-indexed bonds: what are the benefits for issuing countries, investors and international financial stability?”, Quarterly selection of articles – Bulletin de la Banque de France, Banque de France 44, 6–19.  Google Scholar
  12. Carnot, N./Sumner, S. P. (2017): “GDP-linked Bonds: Some Simulations on EU Countries”, Discussion Paper No. 073, European Commision.  Google Scholar
  13. Chamon, M./Mauro, P. (2006): “Pricing growth-indexed bonds”, Journal of Banking & Finance 30, 3349–3366.  Google Scholar
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  22. Lagos, R./Rocheteau, G. (2007): “Search in Asset Markets: Market Structure, Liquidity, and Welfare”, American Economic Review 97, 198–202.  Google Scholar
  23. Leventides, J./Melas, E./Poulios, C./Leventides, R. A. (2021): “Mapping GDP linked bonds: the Greek economy case”, KEPE, Greek Economic Outlook 46, 49–62.  Google Scholar
  24. Lucas, R./Stokey, N. (1983): “Optimal fiscal and monetary policy in an economy without capital”, Journal of Monetary Economics 12, 55–93.  Google Scholar
  25. Moretti, M. (2020): Financial Innovation and Liquidity Premia in Sovereign Markets: The Case of GDP-Linked Bonds, https://mmorettifiles.github.io/Paper 2020 GDPBonds.pdf.  Google Scholar
  26. OECD (2017): The outlook for inflation-linked bonds, OECD Sovereign Borrowing Outlook 2017, OECD Publishing, Paris, https://www.oecd-ilibrary.org/governance/oecd-sovereign-borrowing-outlook-2017/the-outlook-for-inflation-linked-bonds sov b outlk-2017-8-en.  Google Scholar
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  28. Ruban, O. A./Poon, S.-H./Vonatsos, K. (2008): “GDP Linked Bonds: Contract Design and Pricing”, International Finance eJournal.  Google Scholar
  29. Shiller, R. (1993): “Macro markets: creating institutions for managing society’s largest economic risks”, Oxford University Press, New York.  Google Scholar
  30. Shiller, R./Ostry, J./Benford, J. (2018): “Sovereign GDP-Linked Bonds: Rationale and Design”, a VoxEU.org eBook, Centre for Economic Policy Research (CEPR) Press, London, UK.  Google Scholar
  31. Williamson, J. (2017): “Growth-Linked Securities”, Palgrave Macmillan, Springer International Publishing, Cham, Switzerland.  Google Scholar
  32. Arellano, C. (2008): “Default Risk and Income Fluctuations in Emerging Economies”, American Economic Review 98, 690–712.  Google Scholar
  33. Barr, D./Bush, O./Pienkowski, A. (2014): “GDP-linked bonds and sovereign default”, Bank of England Working Paper No. 484.  Google Scholar
  34. Benford, J./Best, T./Joy, M. (2016): “Sovereign GDP-linked bonds”, Financial Stability Paper No. 39, Bank of England, (with contributions from M. Kruger, Bank of Canada, and the Research Department, Central Bank of Argentina).  Google Scholar
  35. Benford, J./Eguren-Martin, F. (2018): “Sovereign GDP-linked bonds: Pros and cons”, in: Sovereign GDP-Linked Bonds: Rationale and Design, ed. by Shiller, R./Ostry, J./Benford, J., 21–28, a VoxEU.org eBook, Centre for Economic Policy Research (CEPR) Press, London, UK.  Google Scholar
  36. Bhandari, A./Evans, D./Golosov, M./Sargent, T. J. (2017): “Fiscal Policy and Debt Management with Incomplete Markets”, The Quarterly Journal of Economics 132, 617–663.  Google Scholar
  37. Bhandari, A./Evans, D./Golosov, M./Sargent, T. J. (2021): “Inequality, Bysiness Cycles, and Monetary-Fiscal Policy”, Econometrica 89, 2559–2599.  Google Scholar
  38. Blanchard, O./Mauro, P./Acalin, J. (2016): “The case for growth-indexed bonds in advanced economies today”, Policy Brief No. PB16-2, Peterson Institute for International Economics (PIIE).  Google Scholar
  39. Bocola, L./Dovis, A. (2019): “Self-Fulfilling Debt Crises: A Quantitative Analysis”, American Economic Review 109, 4343–4377.  Google Scholar
  40. Bohn, H. (1988): “Why do we have nominal government debt?”, Journal of Monetary Economics 21, 127–140.  Google Scholar
  41. Borensztein, E./Mauro, P./Ottaviani, M./Claessens, S. (2004): “The case for GDP-linked bonds”, Economic Policy 19, 167–216.  Google Scholar
  42. Cabrillac, B./Gauvin, L./Gosse, J.-L. (2016): “GDP-indexed bonds: what are the benefits for issuing countries, investors and international financial stability?”, Quarterly selection of articles – Bulletin de la Banque de France, Banque de France 44, 6–19.  Google Scholar
  43. Carnot, N./Sumner, S. P. (2017): “GDP-linked Bonds: Some Simulations on EU Countries”, Discussion Paper No. 073, European Commision.  Google Scholar
  44. Chamon, M./Mauro, P. (2006): “Pricing growth-indexed bonds”, Journal of Banking & Finance 30, 3349–3366.  Google Scholar
  45. Debortoli, D./Nunes, R./Yared, P. (2018): “Optimal Taxation and Debt Management without Commitment”, Discussion Papers in Economics No. DP 01/19, University of Surrey, Department of Economics, ISSN 1749-5075.  Google Scholar
  46. Dovis, A. (2019): “Efficient Sovereign Default”, The Review of Economic Studies 86, 282–312.  Google Scholar
  47. G20 (2017): Compass for GDP-linked bonds, https://www.bundesfinanzministerium.de/Content/EN/Standardartikel/Topics/world/G7-G20/G20-Documents/g20-compass-for-gdp-linked-bonds.pdf?-blob=publicationFile&v=5.  Google Scholar
  48. Ghosh, A./Kim, J./Mendoza, E./Ostry, J./Qureshi, M. (2011): “Fiscal fatigue, fiscal space and debt sustainability in advanced economies”, NBER Working Paper No. 16782, NBER, Cambridge, Mass.  Google Scholar
  49. Hatchondo, J. C./Martinez, L. (2012): “On the Benefits of GDP-Indexed Government Debt: Lessons from a Model of Sovereign Defaults”, Economic Quarterly 98, 139–157.  Google Scholar
  50. Hodrick, R./Prescott, E. (1997): “Postwar U.S. Business Cycles: An Empirical Investigation”, Journal of Money, Credit and Banking 29, 1–16.  Google Scholar
  51. International Monetary Fund (2017): State-contingent debt instruments for sovereigns, IMF Policy Paper May, https://www.imf.org/en/Publications/Policy-Papers/Issues/2017/05/19/pp032317state-contingent-debt-instruments-for-sovereigns.  Google Scholar
  52. Kim, J./Ostry, J. (2017): “Boosting Fiscal Space: The Roles of GDP-Linked Debt and Longer Maturities”, IMF Departmental Paper No. 18/04, International Monetary Fund.  Google Scholar
  53. Lagos, R./Rocheteau, G. (2007): “Search in Asset Markets: Market Structure, Liquidity, and Welfare”, American Economic Review 97, 198–202.  Google Scholar
  54. Leventides, J./Melas, E./Poulios, C./Leventides, R. A. (2021): “Mapping GDP linked bonds: the Greek economy case”, KEPE, Greek Economic Outlook 46, 49–62.  Google Scholar
  55. Lucas, R./Stokey, N. (1983): “Optimal fiscal and monetary policy in an economy without capital”, Journal of Monetary Economics 12, 55–93.  Google Scholar
  56. Moretti, M. (2020): Financial Innovation and Liquidity Premia in Sovereign Markets: The Case of GDP-Linked Bonds, https://mmorettifiles.github.io/Paper 2020 GDPBonds.pdf.  Google Scholar
  57. OECD (2017): The outlook for inflation-linked bonds, OECD Sovereign Borrowing Outlook 2017, OECD Publishing, Paris, https://www.oecd-ilibrary.org/governance/oecd-sovereign-borrowing-outlook-2017/the-outlook-for-inflation-linked-bonds sov b outlk-2017-8-en.  Google Scholar
  58. Roch, F./Roldán, F. (2021): “Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt”, IMF Working Paper No. WP/21/76, International Monetary Fund.  Google Scholar
  59. Ruban, O. A./Poon, S.-H./Vonatsos, K. (2008): “GDP Linked Bonds: Contract Design and Pricing”, International Finance eJournal.  Google Scholar
  60. Shiller, R. (1993): “Macro markets: creating institutions for managing society’s largest economic risks”, Oxford University Press, New York.  Google Scholar
  61. Shiller, R./Ostry, J./Benford, J. (2018): “Sovereign GDP-Linked Bonds: Rationale and Design”, a VoxEU.org eBook, Centre for Economic Policy Research (CEPR) Press, London, UK.  Google Scholar
  62. Williamson, J. (2017): “Growth-Linked Securities”, Palgrave Macmillan, Springer International Publishing, Cham, Switzerland.  Google Scholar
  63. Arellano, C. (2008): “Default Risk and Income Fluctuations in Emerging Economies”, American Economic Review 98, 690–712.  Google Scholar
  64. Barr, D./Bush, O./Pienkowski, A. (2014): “GDP-linked bonds and sovereign default”, Bank of England Working Paper No. 484.  Google Scholar
  65. Benford, J./Best, T./Joy, M. (2016): “Sovereign GDP-linked bonds”, Financial Stability Paper No. 39, Bank of England, (with contributions from M. Kruger, Bank of Canada, and the Research Department, Central Bank of Argentina).  Google Scholar
  66. Benford, J./Eguren-Martin, F. (2018): “Sovereign GDP-linked bonds: Pros and cons”, in: Sovereign GDP-Linked Bonds: Rationale and Design, ed. by Shiller, R./Ostry, J./Benford, J., 21–28, a VoxEU.org eBook, Centre for Economic Policy Research (CEPR) Press, London, UK.  Google Scholar
  67. Bhandari, A./Evans, D./Golosov, M./Sargent, T. J. (2017): “Fiscal Policy and Debt Management with Incomplete Markets”, The Quarterly Journal of Economics 132, 617–663.  Google Scholar
  68. Bhandari, A./Evans, D./Golosov, M./Sargent, T. J. (2021): “Inequality, Bysiness Cycles, and Monetary-Fiscal Policy”, Econometrica 89, 2559–2599.  Google Scholar
  69. Blanchard, O./Mauro, P./Acalin, J. (2016): “The case for growth-indexed bonds in advanced economies today”, Policy Brief No. PB16-2, Peterson Institute for International Economics (PIIE).  Google Scholar
  70. Bocola, L./Dovis, A. (2019): “Self-Fulfilling Debt Crises: A Quantitative Analysis”, American Economic Review 109, 4343–4377.  Google Scholar
  71. Bohn, H. (1988): “Why do we have nominal government debt?”, Journal of Monetary Economics 21, 127–140.  Google Scholar
  72. Borensztein, E./Mauro, P./Ottaviani, M./Claessens, S. (2004): “The case for GDP-linked bonds”, Economic Policy 19, 167–216.  Google Scholar
  73. Cabrillac, B./Gauvin, L./Gosse, J.-L. (2016): “GDP-indexed bonds: what are the benefits for issuing countries, investors and international financial stability?”, Quarterly selection of articles – Bulletin de la Banque de France, Banque de France 44, 6–19.  Google Scholar
  74. Carnot, N./Sumner, S. P. (2017): “GDP-linked Bonds: Some Simulations on EU Countries”, Discussion Paper No. 073, European Commision.  Google Scholar
  75. Chamon, M./Mauro, P. (2006): “Pricing growth-indexed bonds”, Journal of Banking & Finance 30, 3349–3366.  Google Scholar
  76. Debortoli, D./Nunes, R./Yared, P. (2018): “Optimal Taxation and Debt Management without Commitment”, Discussion Papers in Economics No. DP 01/19, University of Surrey, Department of Economics, ISSN 1749-5075.  Google Scholar
  77. Dovis, A. (2019): “Efficient Sovereign Default”, The Review of Economic Studies 86, 282–312.  Google Scholar
  78. G20 (2017): Compass for GDP-linked bonds, https://www.bundesfinanzministerium.de/Content/EN/Standardartikel/Topics/world/G7-G20/G20-Documents/g20-compass-for-gdp-linked-bonds.pdf?-blob=publicationFile&v=5.  Google Scholar
  79. Ghosh, A./Kim, J./Mendoza, E./Ostry, J./Qureshi, M. (2011): “Fiscal fatigue, fiscal space and debt sustainability in advanced economies”, NBER Working Paper No. 16782, NBER, Cambridge, Mass.  Google Scholar
  80. Hatchondo, J. C./Martinez, L. (2012): “On the Benefits of GDP-Indexed Government Debt: Lessons from a Model of Sovereign Defaults”, Economic Quarterly 98, 139–157.  Google Scholar
  81. Hodrick, R./Prescott, E. (1997): “Postwar U.S. Business Cycles: An Empirical Investigation”, Journal of Money, Credit and Banking 29, 1–16.  Google Scholar
  82. International Monetary Fund (2017): State-contingent debt instruments for sovereigns, IMF Policy Paper May, https://www.imf.org/en/Publications/Policy-Papers/Issues/2017/05/19/pp032317state-contingent-debt-instruments-for-sovereigns.  Google Scholar
  83. Kim, J./Ostry, J. (2017): “Boosting Fiscal Space: The Roles of GDP-Linked Debt and Longer Maturities”, IMF Departmental Paper No. 18/04, International Monetary Fund.  Google Scholar
  84. Lagos, R./Rocheteau, G. (2007): “Search in Asset Markets: Market Structure, Liquidity, and Welfare”, American Economic Review 97, 198–202.  Google Scholar
  85. Leventides, J./Melas, E./Poulios, C./Leventides, R. A. (2021): “Mapping GDP linked bonds: the Greek economy case”, KEPE, Greek Economic Outlook 46, 49–62.  Google Scholar
  86. Lucas, R./Stokey, N. (1983): “Optimal fiscal and monetary policy in an economy without capital”, Journal of Monetary Economics 12, 55–93.  Google Scholar
  87. Moretti, M. (2020): Financial Innovation and Liquidity Premia in Sovereign Markets: The Case of GDP-Linked Bonds, https://mmorettifiles.github.io/Paper 2020 GDPBonds.pdf.  Google Scholar
  88. OECD (2017): The outlook for inflation-linked bonds, OECD Sovereign Borrowing Outlook 2017, OECD Publishing, Paris, https://www.oecd-ilibrary.org/governance/oecd-sovereign-borrowing-outlook-2017/the-outlook-for-inflation-linked-bonds sov b outlk-2017-8-en.  Google Scholar
  89. Roch, F./Roldán, F. (2021): “Uncertainty Premia, Sovereign Default Risk, and State-Contingent Debt”, IMF Working Paper No. WP/21/76, International Monetary Fund.  Google Scholar
  90. Ruban, O. A./Poon, S.-H./Vonatsos, K. (2008): “GDP Linked Bonds: Contract Design and Pricing”, International Finance eJournal.  Google Scholar
  91. Shiller, R. (1993): “Macro markets: creating institutions for managing society’s largest economic risks”, Oxford University Press, New York.  Google Scholar
  92. Shiller, R./Ostry, J./Benford, J. (2018): “Sovereign GDP-Linked Bonds: Rationale and Design”, a VoxEU.org eBook, Centre for Economic Policy Research (CEPR) Press, London, UK.  Google Scholar
  93. Williamson, J. (2017): “Growth-Linked Securities”, Palgrave Macmillan, Springer International Publishing, Cham, Switzerland.  Google Scholar

Abstract

We develop and present a model for pricing GDP-linked bonds that takes into account both GDP fluctuations and fiscal default. The indexation is based on the size of GDP deviations from the trend and default is based on the size of sovereign debt. We consider a mapping of these instruments to normal fixed-income securities, and a bond equivalent yield is calculated as well as a default premium. We construct various indexed bond products with different coupon variations and we price them via Monte-Carlo simulations for the case of Greece. The model can be applied to other countries provided that the data are adjusted. One of the main results is that GDP-linked bonds are more conducive to debt management. In particular, replacing conventional bond instruments with carefully designed GDP-linked bonds of equivalent yield can lead to lower terminal values of debt-to-GDP ratio, provided that the macroeconomic environment is the same.

Table of Contents

Section Title Page Action Price
John Leventides et al.: Designing GDP-Linked Bonds with Default 311
1. Introduction 311
2. Foundation of the Theoretical Model 315
3. Mapping GDP-Linked Bonds 317
4. Data Analysis and Estimation of Parameters for the Greek Economy 319
5. Pricing of GDP-Linked Bonds and Equivalence with Plain Vanilla Bonds 321
5.1 Scenario 1 322
5.1.1 Yield of the Bond and Analysis 323
5.2 Scenario 2 325
5.3 Scenario 3 326
6. GDP-Linked Bonds and Debt Management 327
7. A Toy Theorem 329
8. Conclusions 330
Appendix 332
A. GDP of the Greek Economy 332
B. Estimating the Cyclic Part Ut 333
References 334

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