Public Debt Sustainability and Management in a Compound Option Framework

This paper introduces the Asset and Liability Management (ALM) compound option model. The model builds on the observation that the public sector net worth in a multi-period setting corresponds to the value of an option on an option on total government assets. Hence, the ALM compound option model is better suited for analyzing and evaluating the risk profile of public debt than existing one-period models, and is especially useful for analyzing the soundness of exit strategies from the large fiscal expansions undertaken by G-20 countries in the wake of the recent financial crisis. As an illustration, the model is used to analyze the risk profile and sustainability of Australia''s public debt under different policies.Debt management;Asset management;Credit risk;Debt sustainability;Economic models;Group of Twenty;Public debt;Risk management;Asset-liablity management, default risk, Australia, probabilities, probability, public debt management, debt service, sovereign debt, debt sustainability analysis, equation, domestic debt, debt managers, equations, government debt, probability distributions, simulation results, sovereign default, correlation, external debt, debt holders, calibration, monte carlo simulations, external debts, short-term debt, debt maturity, central bank, debt burden, normal distribution, debt structure, repayment capacity, standard deviation, statistics, samples, debt service projections, foreign debt, debt restructuring, debt contracts, domestic currency, stochastic differential equation, simulation approach, currency composition, long-term debt, debt structures, normal distributions, covariance, debt-management strategy, public external debt, public sector debt, debt servicing, sensitivity analysis, private debt, random walk