Pareto : improving default

Abstract

This paper answers the question of whether non-strategic default improves welfare, not only for borrowers with uncertain future income but also for lenders with certain future endowments, relative to no default. We show that the answer is a¢ rmative for a positive- Lebesgue-measure set of individual endowments. Numerical computations show that the size of such endowment set is larger the larger are both the risk aversion and the probability of default. Other numerical examples show that with defaultable securities lenders may nance the purchase of the latter by selling short default-free assets. This portfolio reminds those of hedge-funds such as LTCM.