A balance sheet approach for sovereign debt

A sovereign that is issuing debt denominated in foreign currency is exposed to a mismatch between the value of its assets that can be used to serve the debt, denominated in local currency, and the value of its liability. During economic crisis, when the probability of default by the sovereign increases, there is a tendency for the exchange rate to experience sudden shock. Such a relationship has been observed in most of the recent financial crises in emerging markets (for example, in the East Asian crisis of 1997 and the Russian debt crisis of 1998). In this paper we develop a structural model for pricing sovereign debt that is denominated in foreign currency where the effect of local economic crisis on the exchange rate is considered through a state-dependent jump intensity variable that is sensitive to the distance of default of the sovereign debt. The presented pricing model can produce a higher credit spread than the classical Merton-based approach (1974) for risky debt. The model can help traders, risk managers, accountants, and policymakers who are interested in more accurately evaluating the fair value of sovereign debt that is denominated in foreign currency.