Credit Derivatives and Sovereign Debt Crises

The new markets for credit derivatives allow for buying protection on sovereign debt. This paper considers the implications for sovereign debt crises. We show that the availability of credit protection lowers ex-ante debtor moral hazard by allowing a bondholder to improve his bargaining position in negotiations with the sovereign, thus forcing the sovereign to internalize more of the costs of a crisis. Moreover, we find that equilibrium protection does not hinder an efficient resolution of crises. We even identify situations where crisis resolution is improved by facilitating conditionality. Nevertheless, we show that a bondholder's choice of protection is not always socially optimal. In these cases, increasing the level of protection makes crisis resolution more efficient