SFB 303 Discussion Paper No. B-157

Author: Klein, Martin
Title: The Option Pricing Approach to the Valuation of Country Risk
Abstract: This paper provides a brief survey of some recent developments in the valuation of country risk. The point of departure is the recognition that the valuation of country risk can be approached using techniques developed in the literature on option pricing. The basic setup distinguishes three concepts of debt service. Total contractual debt service, debt servicing capacity, and actual debt service. Insolvency occurs when debt servicing capacity falls short of the contractual debt service. Based on observations of stylized facts of rescheduling it is assumed that under insolvency the debtor country receives debt relief proportional to the difference between contractual debt service and debt servicing capacity. It is then shown that option pricing theory leads to a closed form representation of the spread a country has to pay on its external borrowing.
Keywords: International finance, sovereign risk
JEL-Classification-Number: 123
Creation-Date: June 1990
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