September 16, 2011
We provide a structural model of sovereign credit risk, where the risk premium paid by the government is linked to some key economic variables of a country: public debt and deficit, GDP growth. This model is then applied to measure the impact of splitting the public debt into a senior and a junior tranches and the effect of introducing Eurobonds: in the latter case, tranching is coupled with a cross-guarantee among eurozone countries and with a cash collateral. We show both in theory and in numerical estimates that eurobonds are able to lower the overall cost of servicing the public debt for some (high debt) countries in the euro area, without increasing the cost for the other ones. Moreover, they are likely to give governments an incentive to curb their deficits, due to the higher marginal cost of debt.
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