A Rating-Based Sovereign Credit Risk Model: Theory and Evidence

Abstract

We develop a rating-based continuous-time model of sovereign credit risk with closed-form solutions for a wide range of credit derivatives. In our model, rating transition follows a continuoustime Markov chain, and countries with same credit rating share similar level of default risk. A parsimonious version of our model, with only 16 parameters, one common and one country-specific factor, can simultaneously capture the term structure of CDS spreads of 34 in-sample and 34 outof-sample countries well. On average, the common factor explains more than 60% of the variations of the CDS spreads of both the in-sample and out-of-sample countries, and 80% of the variations of the common factor is explained by the CBOE VIX index, the 5-year US Treasury rate, and the CDX NA IG Index. AbstractWe develop a rating-based continuous-time model of sovereign credit risk with closed-form solutions for a wide range of credit derivatives. In our model, rating transition follows a continuoustime Markov chain, and countries with the same credit rating share a similar level of default risk.A parsimonious version of our model, with only 16 parameters, as well as one common and one country-specific factor, can simultaneously capture the term structure of CDS spreads of 34 insample and 34 out-of-sample countries well. On average, the common factor explains more than 60% of the variations of the CDS spreads of both the in-sample and out-of-sample countries, and 80% of the variations of the common factor is explained by the CBOE VIX index, the 5-year US Treasury rate, and the CDX NA IG Index.

Determinants of Russia’s Sovereign Risk

“…This may be due to the fact that the available data on debt does not fully reflect its true size due to the possible existence of debt in the form of guarantees or subsidies. Li et al (2014) identify the risk premium for a downgrade of the credit rating in the CDS spread by simultaneously modelling the CDS spreads of a set of countries and taking their credit ratings into account. On a 2004-2012 sample, they find that, for a likely change in Russia's credit rating, the premium in the Russian CDS spread is only 1-2%, while the premium for the probability of default (explained by the credit rating) accounts for most of the spread.…”

Measuring Sovereign Risk: Are CDS Spreads Better than Sovereign Credit Ratings?

“…10 Lee, Naranjo, and Sirmans (2014) find that CDS 10 There has been at least one attempt to tie CDS spreads and ratings together in a theoretical framework. Li, Li, and Yang (2014) develop a rating based continuous time model of sovereign credit risk that captures both the cross-sectional and time series properties of sovereign credit spreads. While unrelated to our work, this paper highlights the tight link that can be discerned between CDS spreads and sovereign debt ratings.…”

Three Essays in International Finance

“…They 10 There has been at least one attempt to tie CDS spreads and ratings together in a theoretical framework. Li, Li, and Yang (2014) develop a rating based continuous time model of sovereign credit risk, which captures both the cross-sectional and time-series properties of sovereign credit spreads. While unrelated to our work, this paper highlights the tight link that can be discerned between CDS spreads and sovereign debt ratings.…”