State-contingent debt with lender risk aversion

Abstract

State-contingent debt has the potential to eliminate costly debt crises. Yet, markets for this type of debt remain essentially closed. This paper uses a simple model to show conditions under which specialized risk-averse foreign lenders prefer non-contingent debt to state-contingent debt. Borrowers always prefer state-contingent debt as non-contingent debt increases the probability of default and reduces investment and output. However, lenders face a trade-off between the total surplus generated by the investment project and the share that they appropriate through the financial trade. Even though total surplus is smaller with non-contingent debt when compared to state-contingent debt, the share of the surplus that goes to lenders is larger under non-contingent debt. The paper then characterizes environments where state-contingent debt is more likely to be preferred by both borrowers and lenders under risk aversion.