Credit derivatives and sovereign debt

Abstract

We study the introduction of credit protection on sovereign debt. We find that such protection reduces debtor moral hazard by allowing a bonghokder to improve his position in negotiations with the sovereign. Moreover, equilibrium credit protection does not reduce the efficiency of crisis resolution. We even identify situations where protection facilitates conditionality in crisis resolution. Neverlesless, we show that a bondholder's choice of protection is not always socially optimal. Crisis resolution can then be improved through increasing protection.