The Commonality of Sovereign Credit Risk: A Rating-Based Approach

Abstract

There exists strong commonality in credit risk across sovereigns [Pan and Singleton (2008); Longstaff, Pan, Pedersen and Singleton (2011)]. This paper embeds this commonality into a rating-based, reduced-form model. A parsimonious version of the rating-based model can adequately capture the commonality in sovereign credit markets and jointly fit the CDS spreads of multiple countries. The model's pricing errors are comparable to those of a one-factor model with country-by-country estimation but without resorting to unreasonable parameter estimates. Portfolio analyses suggest that the estimated rating-based model is more consistent with the dynamics of CDS spreads and thus can generate reliable density forecasts for sovereign CDS portfolios.

Keywords: Credit Rating, Sovereign Credit Risk, Credit Default Swap, Systematic Risk, Eurozone Debt Crisis, Implied Credit Rating

JEL Classification: G22, G33