The Pricing of Sovereign Risk: An Application of Option Theory
by Peter Bossaerts of the University of California, Los Angeles
Abstract: Option theory is used here to determine the variables that should explain the price of bank loans to foreign governments. As usual, the key explanatory variable is the variance of the underlying state variable (in casu, government income). It is also shown that these bank loans can often be considered to be riskless in the quantity dimension, because repayment will be made with certainty. They are risky in the time dimension, however, in the sense that banks do not know with certainty the exact moment of repayment.