Measuring and Analyzing Sovereign Risk with Contingent Claims

Abstract

This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. This paper develops a comprehensive new framework to measure and analyze sovereign risk. Since traditional macroeconomic vulnerability indicators and accounting-based measures do not address risk in a comprehensive and forward-looking way, the contingent claims approach is used to construct a marked-to-market balance sheet for the sovereign, and derive a set of credit-risk indicators that serve as a barometer of sovereign risk. Applications to 12 emerging market economies show the risk indicators to be robust and highly correlated with market spreads. The framework can help policymakers design risk mitigation strategies and rank policy options using a calibrated structural model unique to each economy.

The Dynamic Pricing of Sovereign Risk in Emerging Markets: Fundamentals and Risk Aversion

“…Nonetheless, the presumption that credit spreads measure just default risk but not risk premia is common among recent papers in the sovereign debt literature proposing structural models to measure probabilities of sovereign defaults. Gapen et al (2005) and Oshiro and Saruwatari (2005), for example, apply the standard structural Merton model for corporate credit risk by defining for countries concepts of balance sheet leverage and option volatility. They then judge their approaches to be good ones because they find their risk indicators to be highly correlated with market spreads over time.…”

Sovereign asset values and implications for the credit market

“…As the asset value and volatility are based on the balance sheet, the derived asset values and volatilities can be regarded as accounting-based. Gapen, Gray, Lim, and Xiao (2005) provide justification for the CCA approach by calculating risk indicators and CDS spreads based on implied asset volatilities and asset values and compare these to market CDS spreads and other indicators. The calculated spreads perform well in the direct comparison.…”

“…Within the finance literature (cf. Gapen et al, 2005;Gray et al, 2007) it is common to define risk-neutral probabilities by setting μ = r f , where r f is the risk-free rate, e.g. the 10-year-Treasury yield.…”

Choosing the Currency Structure of Foreign‐currency Debt: A Review of Policy Approaches

“…Finally, the third group of numerical approaches, Gapen et al . (2005) and Gray et al . (2005), works with an explicit measure of sovereign credit risk derived from a contingent claim analysis.…”