Stochastic optimal control model of short-term debt<sup>1</sup>

Jerome L. Stein

in Stochastic Optimal Control, International Finance, and Debt Crises

Published in print April 2006 | ISBN: 9780199280575
Published online May 2006 | e-ISBN: 9780191603501 | DOI:
 							Stochastic optimal control model of short-term debt1

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Data on the credit rating of bonds issued in the first half of the 1990s suggest that investors in emerging market securities paid little attention to credit risk, or that they were comfortable with the high level of credit risk that they were incurring. This chapter develops a paradigm for intertemporal optimization under uncertainty in a finite horizon discrete time context, with the constraint that there be no default on short-term foreign currency denominated debt. The object is to select consumption, investment, and the resulting short-term debt in the first period to maximize the expected present value of the utility of consumption over both periods. The constraint is that regardless of the state of nature in the second period, there will be no default on the debt.

Keywords: optimal short-term debt; intertemporal optimization; debt default; credit rating; bonds

Chapter.  7448 words.  Illustrated.

Subjects: Financial Markets

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