Sovereign Default Risk Assessment from the Bottom-Up
32 Pages Posted: 6 Oct 2010
Date Written: September 2010
In 2010, the world’s focus on the global financial crisis shifted from financial markets and institutions to sovereign debt, especially in Europe. This has motivated a re-examination of techniques and traditional indicators to assess the health of individual countries. Since the potential financial and economic implosion of several European countries seemed to erupt fairly quickly, one might conclude that the existing scholarly and practitioner methods were not adequate. We believe that one can learn a great deal about sovereign risk by, in addition to observing traditional macroeconomic measures of performance, to also carefully assess the health and aggregate default risk of a nation’s private corporate sector - - a type of “bottom-up” analysis. Models such as Altman’s original Z-Score technique and more recently, the Z-Metrics’ risk system, can provide important early warning measures of sovereign vulnerability. This study does just that by analyzing the Z-Metrics’ median probability of default (PD) of nine European countries and the USA from two time periods prior to the clear recognition of serious financial difficulties in the Eurosector. Our measures of PDs are also compared to the implied probability of default from a prominent market indicator, the credit default swap market, with both general confirmation and some surprising results.
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