Measuring sovereign credit risk using a structural model approach

Abstract

In this paper, we use three structural models to investigate a country's credit risk by applying it to a sovereign balance sheet. The transformed-data maximum likelihood estimation method and the maximization-maximization algorithm are adopted for model calibration. The derived probability of default over time for four sample countries matched well with the events and economic conditions that occurred during the sample period. Our empirical analyses show that structural models can be used to determine with high accuracy whether the credit of a sovereign country is in a precarious situation. We then illustrate how the structural approach can be an effective tool to monitor the sovereign credit risk.