Measuring the risk of default in six highly indebted countries

The price of debt on the secondary market reflects the risk that the debtor country might default on its external debt. Using the option-pricing theory, the authors identify the factors that influenced the risk of default in six highly indebted countries (Argentina, Brazil, Chile, Mexico, Venezuela, and Poland) from 1986 to 1990. In particular, they provide a measure of the debtor countries'willingness to pay. They identify the parameters of the stochastic process followed by this variable, so this approach can be used to predict the future price of debt. Their model also emphasizes that a debt-reduction operation may lead to a significant increase in the price of debt on the secondary market. This effect appears to be linked to the initial stock of external debt, as suggested by the debt overhang hypothesis. Finally, the authors show empirically that a country's willingness to pay is significantly influenced by changes in indicators of thecountry's ability to pay (for example, by an increase in reserves or in GDP growth), and by exogenous events such as the increase in commercial banks'loan reserves in mid-1987 or the Brady Plan announcement in 1989.