Contingent Claims Approach to Measuring and Managing Sovereign Risk
Dale F. Gray
International Monetary Fund (IMF); MF Risk
Boston University - Department of Finance & Economics
Robert C. Merton
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit
Journal of Investment Management, Vol. 5, No. 4, Fourth Quarter 2007
This paper proposes a new approach to measure, analyze, and manage sovereign risk based on the theory and practice of modern contingent claims analysis (CCA). The paper provides a new framework for adapting the CCA model to the sovereign balance sheet in a way that can help forecast credit spreads and evaluate the impact of market risks and risks transferred rom other sectors. This new framework is useful for assessing vulnerability, policy analysis, sovereign credit risk analysis, and design of sovereign risk mitigation and control strategies. Applications for investors in three areas are discussed. First, CCA provides a new framework for valuing, investing, and trading sovereign securities, including sovereign capital structure arbitrage. Second, it provides a new framework for analysis and management of sovereign wealth funds being created by many emerging market and resource rich countries. Third, the framework provides quantitative measures of sovereign risk exposures which facilitates the design of new instruments and contracts to control or transfer sovereign risk.
Keywords: Contingent claims analysis, sovereignrisk, Merton Model, capital structure arbitrage
JEL Classification: G00
Date posted: January 17, 2008
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