Contingent Claims Analysis of Sovereign Default Risk in the Eurozone
41 Pages Posted: 24 Apr 2017 Last revised: 22 Oct 2017
Date Written: October 1, 2017
We study sovereign default risk as measured by credit default swap (CDS) spreads of Eurozone member states between 2008 and 2016. Applying a structural credit risk model we analyze to what extent contingent claims analysis can explain spreads given fundamental balance sheet information. First results confirm that market implied default risk is hardly explainable by available fundamentals. We therefore model the asset value with a jump-diffusion process, which we calibrate to market implied default probabilities. The resulting jump intensities are substantial for both, distressed as well as non-distressed countries. By extending the jump-diffusion model and considering the first-passage time default possibility, our model is able to represent more realistic proportions of jump and pure diffusion risk. Including the first-passage time feature and analyzing conditional default probabilities via correlated jump-diffusion processes further contributes to the analysis of credit contagion and systemic risk. Our approach documents that the largest systemic risk component of the periphery comes from Italy, the smallest from Ireland.
Keywords: Structural credit risk model, jump-diffusion, first-passage time, sovereign default risk, credit contagion
JEL Classification: G12, G13, H63
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